Facebook Derivatives: Wall Street Goes Rogue-er
paul.kedrosky.com
paul.kedrosky.com
Depends on the way they'll do this, one way is that they could approach some major stakeholders of Facebook (e.g., a pool of employees with vested or unvested employee stock options) and draw up some agreement with that entity to buy the rights to buy these stock options at a whole-sale strike price (let's say $0.05/share to buy the share at $75).Then the brokerage firms will chop these options to different strike price bins and re-distribute to investors (e.g., $0.15/share for the right to buy the share at $75, $10.15/share for the right to buy the share at $65; with the broker collecting a $0.10/share underwriting fees.).
So you are buying an option at a certain strike price to buy a potentially unvested option to buy a illiquid, pre-IPO stock at a certain strike price. If this was Google in 1999, someone is going to be rich. But since it is my opinion that Facebook is going to the way of AOL, I wouldn't buy into it; but then again, it depends on when Facebook is going to IPO and if it is before the Web 2.0 exuberance dies down.
You just described an index fund (albeit with only one stock in the index).
Bucket shops are nothing like this - bucket shops are casinos where the source of random numbers is the stock market, but no shares are ever traded.
I don't think so - we're not talking commodities here, but equity. Every index fund I've seen or traded had multiple underlying assets, even if some of them were derivatives...
BTW, stock market must be pretty bad random number generator...
This is just a pretty standard private investment setup, that just happens to own a single stock.
Even if owning the single stock was a problem - and I don't think it is - working around it would be trivial. They could invest small amounts in a number of very low value stocks or in very stable stocks. Both those strategies would meet any hypothetical "diversification requirement" (which I don't think exists) without materially changing their exposure to Facebook.
What you describe here sounds like dark pools[1].
The business model, at least in the 1920's, was to get customers to take big positions on margin, then to manipulate the actual stock (on an actual exchange) to the point that customers were wiped out. If the manipulation cost less than what the customers put up, the bucket shop would win.
People occasionally accuse forex companies of doing something similar, but the market is probably too deep for any retail-facing forex company to successfully manipulate prices like this.
Reminisces of a Stock Market Operator talks about bucket shops--and trading against them--in detail.
Most, if not all of low end forex (at least the more honest ones spell it out in fine print) is basically a bucket shop.
You are buying(betting) against the house, that is all.
Unless I'm missing something, the story here is that people are pooling money to setup a company to invest in Facebook. That's just normal investing - exactly like investing in a VC fund that invested in Facebook.
I suppose technically they are investing in a Facebook derivative, because they get returns from the investment company rather than Facebook stock directly. But people don't say a Vangaurd find is a Walmart derivative just because it invests in Walmart, nor do they say investing in the Accel Funx X (which funded Facebook) is investing in a Facebook derivative.
I believe these are derivative because they aren't buying the stock directly, but purchasing rights to them.
This is done to Fortune 500 CEOs option/stock pools to sell off their rights to purchase others' rights to their stock for the sake of diversification without selling publicly and causing a scare - to the board or investors.
Derivatives in that sense are used to add some leverage on a bet and are known for their high risk, compared to the risk in directly owning their underlying equity securities. They aren't directly related to the underlying (same idea in calculus: y = f(x) ≠ dy/dx). I don't see how this adds additional risk in addition to the risk associated directly with owning Facebook stock.
While this technically is a derivative (underlying is Facebook stock), I think using the term "Facebook derivative" is a bit misleading.
But yes he does seem to have a Master's and Doctorate in finance, and he's worked in the financial industry; it looks like he's not a complete quack. But his blog is not a balanced, objective study of economics, either - it's more infotainment than academic discourse (at least that's my impression after a 5 minute visit of it).
Also, it's not a "scare word" in this context at all. It's a fairly neutral term, and an accurate enough description of what these investment firms are doing (even if they chose to use other words to market these instruments).
Of course it's technically a neutral term. But in this context, it is a scare word. When you write a blog that seems to be a pop topic blog for a wide audience, in today's world 'derivative' is a scare word. The average news paper reader hadn't heard about 'derivatives' before 2008, and since then he heard about it every week, usually in the context of how much money they have cost some firm, how much money they have cost the tax payer, how much money they have cost pension funds, or how much money they have made for those greedy bankers in Wall Street, London, Frankfurt or wherever - or a combination thereof.
So yes, 'derivative' is a term with negative connotations to the wider public. It is one of the words that are now associated with irresponsible risk and money out of thin air. It's irrational to blame the use on the instrument, but hey, it's an irrational world out there.
This is very similar to how traditional VC funds are structured and the only reason this is getting press is because it is another story about Facebook.
These funds actually do a service for the original Facebook shareholders because it allows them to take some cash off the table, rather than waiting for the IPO.
It's possible that the funds offering statement lays out a clear goal, but also provides enough flexibility to employ some fancy engineering techniques. Then they raise funds and put the capital to work. Due to the illiquid nature of the target company, it wouldn't be surprising if the fund assets end up being a mix of synthetics, equity shares and employee stock options.
Regardless, the article doesn't really provide enough information to draw a firm conclusion.
Just facts,
1) Creating a derivative market on Facebook employee options creates value for the Facebook employees because it means that they can now sell their options in a more liquid and better-priced market for cash (to potentially finance their kids education, help buy for a house or for hookers).
2) High frequency/automated trading tightens the bid-ask spread of stocks and does away with the "old boys" network of market-makers; making the purchase of stocks for both mutual funds/retail investors cheaper by $0.02/share-$0.05/share; at a volume of 4+ billion shares daily average volume. These cents add up to savings for market participants. But these machines could also turn around and manipulate the market and help save for hookers for traders/programmers who run them.
3) Weather derivatives, like other derivatives do have intrinsic values. For hedgers (such as hotels/ski slopes/airline industry/agriculture harvest that could be severely affected by inclement weather), they are insurance policies against risk that they are not willing to bear and help ensure that these businesses stay in business. However, if you have an army of Physics PhD who could model the risk/probability in weather derivatives; you could sell these insurance policies and make money to get hookers.
In "A Colossal Failure of Common Sense" there is a description of trading in distressed corporate bonds - I always wondered how you actually make money in bond markets and this was an interesting (to me) example of a scenario where what they were doing was obviously profitable and useful.
People who think they have edge will invest, and so will some people who don't have a clue what they're doing. Some people will fit into both categories. I think that's true of investing generally.
you're unable to make an objective assessment of
the underlying value
Which would be a far more convincing argument if it wasn't the fashionable thing in the tech industry to try as hard as possible to never grow old and fat.
He provides no justification for this statement. Why is it these things? Given the title of his blog, I'm assuming he has a pre-disposed bias on such matters.
I would think this is heading for trouble, though. The SEC and public policy in this area are oriented toward protecting non-accredited investors (let's call them "noobs") from the potential hazards of stock ownership (getting "pwned").
Now that being public (and even widely-held) is onerous, setting up a noob-free server (a private market) seems like a win. The company gets liquidity, the noobs have no chance of getting pwned, everyone should be happy.
But this particular innovation is a little concerning, because it's primarily going to appeal to noobs and the total amount of noobs at risk of pwnage can get much larger than intended. That's when the regulators are going to step in. So as clever as this seems, this is just begging for trouble.
Google ran into the same problem in the run-up to their IPO
Today, I presume they don't need to hassle with non-accredited investors because the demand is so huge. But the door would seem to be open to this in the future since there's not much to stop it, possibly apart from Facebook's control over transactions.
I admit it's a far-ahead concern. But it's a real danger.
They do here in most of Europe, there are plenty of shady investment opportunities here for people with more than 50k to invest - to the point where my spidey sense starts to tingle when I see a commercial on TV saying 'minimum inlay 50k'.
(come to think of it, haven't seen many of them over the last year or so - a couple of people went to jail or worse over some real estate funds gone sour, seems to have stopped that industry dead in its tracks).
It's not much different than NYSE:GLD.
If people feel that it's a poor investment strategy they don't need to invest in it. This whole model is probably a phenomenal way to get public money into a private company and avoid all that regulatory BS that public companies need to go through. (Note: If you think the regulations are great then just avoid investing in this kind of company)
Out of curiosity, what does this imply for stock options? Are people who exercise them included in this count?
They have been replaced by, you guessed it, derivatives.
In any case, the company presumably has a right of first refusal clause on their stock, which means that Facebook can match any stock buyer's offer themselves, or broker a trade to someone else instead. That's only in case of emergencies, though.
A lot of other companies did so around that time, since this was following the accounting standards change which required options to be expensed. If you're going to expense options, you might as well expense something more flexible.
http://www.businessweek.com/technology/content/nov2008/tc200...
The second market in Facebook is definitely pushing the envelope, a role of the SEC is to make sure people don't get ripped off and are treated fairly.
Clearly promoters shouldn't be able to sell private unvetted securities to the public without registering and going IPO on a public exchange. But it's also not clear it's in the public interest to have second markets only the well-heeled have access to, and that are not subject to public securities regulation, public price discovery and disclosure through K and Q filings. Maybe it's also not right to force Facebook to choose between going public prematurely and issuing shares/options to employees, but at some point for those shares to be properly valued the stock has to be publicly traded.
When they got the exemption they said it was just to give shares to employees, not to create a second market. The rules are getting rewritten (or Wall Street is running rings around them as Kedrosky says).
I fundamentally like the second market idea a lot because I like private companies staying private for as long as they want while still giving employees options for ownership that are at least somewhat liquid. It's really fascinating to see the mechanisms involve creaking at the joints a little, but I think the idea is solid.
> They have been replaced by, you guessed it, derivatives.
Stock options are derivatives. I'm not sure what distinction you are making. It seems like the term is being used for scare-mongering rather than serious analytical discussion.
But yes, I am poking fun at the problem solving methodology which says "just make a more complicated derivative."
Clearly, "because private-company financials are opaque" investing in the derivatives is speculative. The securitization of Facebook shares is not inherently "evil", but the issues arise if/when these derivatives are misunderstood and overly available for public consumption.
Note that there can be no solicitation or advertising of the offering to the general public. In practice, as you can see, this means you can leak all the details to Bloomberg but then cannot comment for the story. Because, you see, that would be solicitation.
The key is that these derivatives are synthetic shares of facebook, not true equity. When available/required, the fund will acquire these shares.
The difference btw this and mortgage CDS, is that this is "equity", not debt.
That's my reading of it anyway. Here's another attempt at an over-simplified explanation: http://news.ycombinator.com/item?id=1936037
In other words, it seems like all assets are paid for already with the inlay of the shareholders of the investment vehicle. So I think that disqualifies it as a long, where no cash changes hands at the time the deal is done, no?
Then again it seems to be that the scary stories and the bad image of shorts and longs are about the naked variants, and that this is implicit in the article. That may just come from my lack of grasp on the subject.
Here's a puzzle in the spirit of building the series of logical gates by combining NAND gates. You could learn enough about the concepts using wikipedia. Consider a scenario: the government bans short-selling. Your task: find a way you could synthesise a short using just forwards.
What are some practical considerations that might make it less practical to do this than pre-ban shorting?
I find that when I understand how something emerged, I have a good feel for it. A lot of these concepts go back a long way - stock practices that developed through trading stock of the dutch east india company. For this reason, I'd recommend Niall Ferguson, _The Ascent of Money_. Das _Traders, Guns and Money_ is a good read. I couldn't follow all of it when I read it, but found it to be good for feel.
There's a late 20th century writer John Kenneth Galbraith who wrote some good histories. I like _the end of uncertainty_ but it's hard to get. He wrote others that will be fine.
It would probably be useful to read a book about Drexel Burnham Lambert, and how Milken developed their junk bond trades. I don't know of one, perhaps someone else can recommend.
For broader economic picture stuff, I recommend Hazlitt _Economics in One Lesson_; Schiff _How an Economy Grows and Why It Crashes_; Soros, _The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means_.