All That Glitters...

What we can learn from The Merchant of Venice about risk.

All that glisters is not gold—
Often have you heard that told.
Many a man his life hath sold
But my outside to behold.
Gilded tombs do worms enfold.
Had you been as wise as bold,
Young in limbs, in judgment old,
Your answer had not been inscrolled
Fare you well. Your suit is cold—

— William Shakespeare, Merchant of Venice, Act II Scene 7

Risk Developments this letter:

  • Fraud and Surveillance

  • Cybersecurity Winners and Losers

  • Infrastructure; Archetypes of Conflict

  • Insurance Industry Woes 2020

  • Startups Betting on Risk

  • National Security Bulls

St Mark's Basilica, Venice

The Merchant of VC

Shakespeare’s The Merchant of Venice, religious and ethnic issues aside, is one of his plays that is easiest to imagine in modern times. It feels very familiar to a Silicon Valley startup quest in which the romantic entrepreneur seeks capital to fund his journey, defy the odds and wins the prize, only to come home to a legal mess that nearly causes him to lose his friends and his honor (if anybody wants to write the modern startup screenplay of The Merchant, I’d gladly read it). This is in part because its source is more modern than many of Shakespeare’s other plays, but also because Italy is the origin of many modern commercial institutions. Double entry book keeping in Europe dates back to Genoa (Venice’s rival) in 1340. Insurance for ships was first offered in Pisa in 1343. But it is the unique corporate form that arose in Venice, which allowed for shared risk taking and positive sum games. Through the prism of honor, reputation and risk, The Merchant of Venice takes on fresh life.

One recurring theme in the play is the difference between the risks characters think they are taking and the risks they are actually taking. Risk professionals call this model risk. When a model fails (because it is wrong, improperly used, or poorly implemented), it is a sort of meta-risk. The risk that your thinking about risk is wrong. This type of risk is pernicious because you may be able to properly address what you thought the risk to be, giving you a false sense of confidence.

For example, Antonio, the protagonist, asks his friend Bassanio for money because he believes he needs to impress the object of his affection, Portia. It turns out that she is bound by her late father’s will to only marry the man who can solve his riddle. Classic entrepreneur, raising money when they actually need to discover a hidden truth.

Bassanio agrees to help Antonio, but he is having cash flow issues so he lends Antonio his credit, assuming he will exit his investments shortly. Unfortunately, his investments, trading ships out to sea, all get destroyed in a storm. Bassanio thinks he’s taking trade risk, but it becomes clear he was taking natural catastrophe risk.

Shylock, the unyielding money lender, who gives Antonio the cash, ends up losing his daughter. She runs away with her Christian lover and rejects not only her family, but also her religion. Shylock thought he was taking credit risk, but the real risk was alienating those he loves through his lack of mercy and grace.

Onward to current events in risk!

Fraud and Surveillance

The bad news is allegations of misrepresentation, manipulation and outright fraud continue to pile up. The good news is this is a leading indicator of growth in the surveillance industry. OK, maybe you do not find that good news. The always excellent Byrne Hobart at The Diff has a recent piece on The Right Amount of Fraud. From a public policy perspective, some fraud is an acceptable risk. The corollary here is that some level of surveillance is an acceptable risk.

The difficulty in both cases comes from the interchangeability of opportunistic hazards and long-term planned hazards. As Byrne points out, some opportunistic fraud is the cost of doing business. This kind of cheating is difficult to point out ahead of time, but relatively simple to track down. Surveillance inverts this relationship. You want long-term, well thought out surveillance of traders who could go rogue or collude to move prices, but you don’t want opportunistic surveillance with which executives play office politics or intimidate journalists. This creates an asymmetry between fraudsters and systems designed to catch them that cybersecurity is well aware of:

Cybersecurity Winners and Losers

Speaking of cybersecurity, our continuous push towards digitization is creating a new set of winners and losers. As cybersecurity becomes the cost of doing business, cybersecurity companies increasing get a share of the revenues of every company transacting online. This has created news roles, new companies, new investment opportunities and new ways to evaluate chief executives. Cui bono? The rich and the upwardly mobile.

Growing markets with unclear qualifications tend to benefit those with experience and those with few other options. The former because experience is the only signal available, so it tends to get too much weight, and the latter because unclear qualifications level the playing field among people willing to start at the bottom. This isn’t just happening in the labor market. Companies too have a barbell distribution in cybersecurity. Small enough, and you don’t have much to lose or aren’t worth the effort. Big enough, and you can afford another fixed cost as long as it raises barriers to entry. In some ways this is just another story of the hollowing out of the middle class, only this time it’s on a global scale.

Infrastructure; Archetypes of Conflict

Regarding that global scale, small telecom companies in the U.S. had been relying on Chinese manufacturer Huawei’s cheap equipment to build out their networks. Now the FCC is tapping an $8.3B fund to rip and replace $1.8B of Huawei equipment. This is an interesting story for at least two reasons. First, it is a classic man against man conflict. Second, the way it is being resolved is the Federal Government stepping in to bail out bad supply chain choices by regional businesses.

In other infrastructure archetypes of conflict, Halliburton, Explor and AWS have vastly reduced the cost and time of oil exploration data analysis. This man against nature conflict is being resolved by combining available technologies. If we do ever manage to innovate in the world of atoms again, it will be first by simulating that world in bits, as Hall-exp-azon has done here.

One place it is incredibly hard to apply technological innovation to is safety and regulation. The U.S. nuclear industry has been plagued by inability to build new nuclear plants, and therefore our stock of nuclear energy facilities is aging. The Seabrook plant 40 miles outside of Boston just won permission from the Nuclear Regulatory Commission to continue to operate if it addresses degradation in concrete. This man against self conflict of nuclear power in the U.S. is a psychological thriller. Will we, or will we not use nuclear power? Our nation’s own guilt and fear has held us back while countries like France, Slovakia and Ukraine generate more than half of their power through nuclear.

In other energy infrastructure news, the U.S. is backing a $1.5B political risk insurance package for natural gas liquification in Mozambique. Just one year ago the ruling FRELIMO party and the opposition RENAMO party signed a peace treaty, but conflict has been echoing since the Cold War when the FRELIMO was a Marxist-Leninst party. Long time RENAMO leader, Afonso Dhlakama, died in 2018, although the party had lost is main benefactors on the right years ago, as Cold War coalitions collapsed and FRELIMO pivoted from socialism to social democracy. This classic man against society story, ends with society the victor, but a kind of society much closer to what Dhlakama was fighting for. Sometimes we confuse the risks and sometimes the goals.

Lastly, this sobering story about how wildfire risk could translate into financial risk, seems almost fated to happen. Global warming, more frequent fires, rising home costs, reduced insurance coverage, shaky local finances and jumpy markets all seem to be conspiring to make this happen. It does seem like some dues ex machina will be required to sort out this man against fate conflict. Then again, other War of the Worlds predictions have come true. Why not being saved by a killer disease?

Insurance Industry Woes 2020

Even if Corona Virus bails us out from wildfire induced financial collapse, it is not going to be good for the insurance industry. Between the uptick in natural catastrophes and Covid-19, the industry is slumping into its third straight year of not earning its cost of equity. Reinusurance in particular has been having a tough go of it. Not only has the industry been hit hard by the impact of losses related to the pandemic, but the continued low interest rate environment for the foreseeable future also puts pressure on their ability to earn a return on their float to meet future losses. The industry put aside substantial reserves for Covid related losses and it looks like the losses will be manageable, but the real risk was the government response to the impending financial crisis, which will suppress returns for years to come.

Tech Betting On Risk

In one bright spot of insurance news, Duck Creek Technologies, a major provider of insurance middle office software is partnering with FICO to offer cyber risk data in its underwriting tool. Duck Creek, fresh off its IPO, has been a long time provider of policy management, billing, reinsurance and generally software to managing the insurance supply chain. It seems that one area they see growth after IPO is in helping their customers avoid some types of model risk.

In other tech risk bets, market liquidity startup Capitolis raised $11M from J.P. Morgan, Citi, State Street. It’s good when you can raise money from your customers, and especially good when you have a network effect. Capitolis nets out derivative positions freeing up capital to use as collateral for new trades, which lowers their cost of capital. This is incredibly good for customers with large balance sheets, that have a multitude of positions and are constrained by collateral, not demand. Fortunately, these customers are price insensitive and all talk to one another. Unfortunately, there are not a lot of these customers, and the ones who don’t have equity may rather build their own systems to spite their competitors rather than take a good deal. The bigger risk here may be doing the deal than not doing it.

National Security Bulls

It’s easy to forget how big defense budgets are. The command, control, communications, computers, intelligence, surveillance, and reconnaissance (C4ISR) budget will to tick up at a 1.5% CAGR over the next five years. Command and control warfare continues to expand into electronic and space domains. Expect to see more cybersecurity in space as satellites, reconnaissance, data processing and communications technology continue to converge. AWS is investing $10B in low-Earth orbit satellites to provide broadband.

I don’t doubt the importance of space and electronic warfare to security, but there is always the chance that we are looking to mitigate the wrong risks. Climate change and biosecurity look to be the unaccounted for risks from a national security perspective. Maybe there are other ways of addressing these risks outside of defense/intelligence directly.

In closing, I’d like to say a brief word about the Oracle TikTok tie up. Some people identified TikTok as a national security risk a while ago. This unpopular view, is in my estimation, correct. Still, sometimes the cure is worse than the disease, and living in an open and free society means nobely suffering the slings and arrows that other societies won’t. This apparent weakness is a great cultural strength, and one of the pillars of America’s soft power. Still, information warfare is real and dangerous. So what can one do when, like Antonio in The Merchant of Venice, morality and markets collide? Well, if Portia is any guide, get a good disguise!