Rational Risk, Part II
What Crime and Punishment can teach us about risk: Crypto Crime; Swiss Risk; Cyber Landscape; Cyber PE; Rockets and Missiles; Satellites and Space
I wanted to become a Napoleon, that is why I killed her...
- Rodion Raskolnikov, in Crime and Punishment by Fyodor Dostoevsky
Risk Developments this letter:
Crypto Crime
Swiss Risk
Cyber Landscape
Cyber PE
Rockets, Missiles
Satellites and Space
Material Risk, Metaphysical Risk
Last week’s discussion of “Crime and Punishment” ended by recounting the third grisly death described by Dostoevsky in the early part of the novel. The alcoholic, failed civil servant and negligent father, Semyon Marmeladov, had been run over by a carriage and trampled by a horse. Comparing this to Rodion Raskolnikov’s murder of the old pawn broker presents an opportunity to investigate the role of chance and will in risk.
Following the action packed first two parts of the novel, the next three parts are intensely social and metaphysical. Rodion and the police inspector engage in a game of cat and mouse. Meanwhile Dunya, Rodion’s sister, attempts to escape her desperate situation as governess to the family of Arkady Svidrigailov, a depraved sensualist, by marrying Pyotr Luzhin, a deceitful and power hungry lawyer. Again, Dostoevsky instructs us in the temperament of these characters through their names. Dunya (short for Avdotya) means good judgement. Arkady is a reference to Pan, the Arcadian god of of wild sexual depravity and the hunt. Pyotr Luzhin recalls both Peter the Great and the Luzha River, where Napoleon met his downfall.
The phantom of Napoleon looms over “Crime and Punishment” ( he is mentioned 16 times), just as it did over Russia during Dostoevsky’s lifetime. Rodion compares himself to Napoleon throughout and has many clashes with Luzhin. The penultimate fight takes place in front of Dunya, who decides she cannot marry such a cruel and angry man as Luzhin. Rodion’s symbolic victory is short lived as, like Napoleon retreating from Moscow, he abruptly announces to his mother, sister and friend, Dmitry Razumhin, that he must leave and may never see them again.
The final battle between Luzhin and Rodion takes place at the funeral banquet of Semyon Marmeladov. Semyon’s wife, hysterical and haughty, has spent the only money they have on the banquet in an attempt to demonstrate her status, but when the poor and ill mannered guests show up to eat free food and get drunk, she throws a tantrum. At the height of her apoplexy, Luzhin enters the scene to frame Sonya, Semyon’s pious and virtuous daughter, for stealing from him, only to be undermined by Luzhin’s socialist roommate who observed the whole setup.
By this point Dostoevsky has pushed all his chips into the center of the table, and the only thing left is to flip over the remaining cards. The only two unresolved issues are:
Will Svidrigailov succeed in conquering Dunya?
Will Rodion’s will give out under constant assault by his conscience?
Girard’s card playing metaphor we discussed in part one is apt, not only because Dostoevsky was a degenerate gambler, but because it is the same metaphor used by the famous sociologist Erving Goffman, which I wrote about at length here. The significance of gambling in our modern age has only compounded since Dostoevsky’s time. Wallstreet Bets, cryptocurrency, land speculation, alltime high startup funding, even Russian incursions into Ukraine and Chinese tactics in Hong Kong are forms of action in the Goffmanian sense. Goffman refers to risk taking as the presentation of self for the demonstration of strong character traits such as courage, gameness, integrity and composure.
This view of risk stands in contrast to the rational view, that is, Elroy Dimson’s definition of risk as “more things can happen than will” or famed economist Gary Becker’s view of the criminal. In Becker’s famous paper, “Crime and Punishment: An Economic Approach,” he posits a rational actor who calculates the probability of being caught, weighted by the penalty they would face, against the size of the score. He concludes that, since it is cheaper for states to increase punishment than to increase the efficacy of law enforcement, one way to reduce crime is to up the penalty. This theory drew popular support and became known politically as being “tough on crime.” Deterrence, however, has been shown to be fairly ineffective both at the local and international levels. The flip side of this theory is to increase the upside for pro-social risk taking. Larger payouts for entrepreneurs, aligning executive pay with shareholder interests through use of options, stronger IP protections for novel technologies and a slew of other incentives likewise became popular in public policy.
This romantic view of risk, a throwback to gallant knights or cowboy heroes, is a failure to understand the psychology of risk. Just compare the popularity of quintessentially romantic risk takers, Luke Skywalker and Superman to their anti-hero counterparts, Han Solo and Batman. While rationality opens the space for utopian romanticism by dethroning old hierarchies, as in the French Revolution, it ultimately turns on itself leading to unbridaled cynicism or nihilism. Rodion, has discarded sacred rules in favor of rationality, but worship of rationality is worse than worship of the sacred. Without the moral underpinning, the only choice is between the immorality of Luzhin and the amorality of Svidrigailov. Rodion’s desire to be Napoleonic is the ultimate sign of modernity that culminated in the calamities of Communism and Fascism.
Today we are faced with a new challenge, not yet described by “Crime and Punishment.” The post-modern world, arriving after the fall of Communism, shares many similarities with romantic rationalism, it is a period of innovation worship and mythologizing of risk takers, but it is insincere, because we are constantly taught about the corruption of utopian schemes in history, in the unrelenting news cycles and the cannibalistic environment of social media, which consumes our modern heroes just as they are elevated to Napoleonic status.
The Napoleons of today are anti-heroes, brash entrepreneurs and autocratic strongmen. The nihilist phenomenon is even apparent in technology as the worship of artificial intelligence takes primacy in our tech narratives. Liberal open societies struggle in the AI arms race against omniscient authoritarian regimes who have the decided advantage in data gathering and surveillance with which to train their models. The proposed foil to AI, cryptocurrency is antithetical to the state and the refrain used to justify its value, that “something has value because people believe it has value,” is just as rationally irrational as the belief that it is ok to do whatever makes you happy because it makes you happy. Again, we are trapped between Luzhin’s immorality and Svidrigailov’s amorality.
Doestoevsky had first hand experience with this conundrum. His early works, sympathetic to socialist utopianism, spoke out against the oppression of the lower classes. He was sent to Siberia for reading aloud a scathing critique of Gogol’s support for traditional heirarchies against the socialist utopian cause. When he returned, he was a changed man. Personally he remained addicted to his vices, but intellectually he was opposed to both amoral hedonism and extreme rationalism. Likewise, those engaged in risk taking, whether in finance, technology or diplomatic affairs, must avoid the temptations to dance while the music is playing or attempt to rationally engineer out all risk.
How this is to be achieved is not exactly clear, but Doestevsky proposes some hints in the last two parts of his novel and his next few works. Mindfulness (Dmitry Razumhin), wisdom (Sofya Marmeladov) and devotion (Dunya Raskolnikov), are the antidote to the extremes of fetishizing rationality and giving up all hope. Goffman’s work is also instructive here. Fateful action, that is, problematic (i.e. soon to be resolved) and consequential (i.e. with a payoff that exceeds the bounds of a specific game) risk taking, is best approached as what Goffman calls a “practical gamble.” The ability to categorize, identify and endure are the hallmark of great risk takers. Mindfulness, wisdom and devotion, or in Goffman’s terms, care, providence and defense are the guardrails on the narrow path between cynicism and nihilism.
As promised in part one, we will turn back to Albert Camus, and in part three address Jünger, who completes “Crime and Punishment” by providing a coda to the movement Dostoevsky left unfinished. Camus, who died at the peak of his intellectual achievements proposes this synthesis in “The Rebel”:
But historical absolutism, despite its triumphs, has never ceased to come into collision with an irrepressible demand of human nature, of which the Mediterranean, where intelligence is intimately related to the blinding light of the sun, guards the secret. Rebellious thought, that of the commune or of revolutionary trade-unionism, has not ceased to deny this demand in the presence of bourgeois nihilism as well as of Caesarian socialism. Authoritarian thought, by means of three wars and thanks to the physical destruction of a revolutionary elite, has succeeded in submerging this libertarian tradition. But this barren victory is only provisional; the battle still continues.
Risk Developments
Crypto Crime
Bitcoin mixing has long been the solution to the non-repudiation feature inherent in the blockchain. While bitcoin derives much of its promise from its anonymity, its solution to the double spending problem relies on the incorruptibility of its public ledger. This poses a problem for those who wish to use bitcoin to avoid capital controls or other illegal activities. Governments may not be able to directly identify a wallet’s owner through signals intelligence alone, but paired with human intelligence they can trace the transfer of bitcoin from a deanonymized source. This means that deanonymizing just one node in a series of transactions can unravel the anonymity of anybody in the chain.
This appears to be what happened in the recent $336M bust of a bitcoin mixing magnate. While this tactic is similar to the approach used in the takedown of Silk Road and its owner, the Dread Pirate Roberts (A.K.A. Ross Ulbricht), it is to my knowledge the first time a government has successfully taken down a large mixing operation. These operations are honeypots because just using a mixer implies that the user has a good (i.e. criminal) reason to avoid deanonymization.
Swiss Risk
The risk management fallout from the Archegos and Greensill incidents at Credit Suisse have already found one victim and may claim more. Chief Risk Officer, Lara Warner was removed from her post earlier this month amid criticism that she had made the risk function too commercial. It’s a tough job running a cost center in any company and that job is only made tougher by the difficulty of attracting top talent, who shrewdly identify cost center jobs as career dead ends. As Matt Levine pointed out, the job of a Chief Risk Officer is not to avoid all risks, otherwise your competitors will get all the juiciest deals and your firm will develop a reputation as a wet blanket.
On the other hand, you can’t just become a deal facilitation department to justify the career ladder required to attract high achievers. Then you’ll end up ignoring multiple red flags and eventually take down the whole bank. The incentive structure just isn’t built for “practical gambling,” but who designs the incentive structure?
Well, in some sense, that’s what a board of directors is for. Now it appears that the director that chairs the risk committee at Credit Suisse is coming under fire from shareholders, and apparently he’s considering stepping down. On the one hand, he’s the chair of the risk committee, it’s kind of up to him (and the rest of the committee) to oversee the risk management system and, if deemed inadequate, design the proper incentives for reform. On the other hand, risk is just an externality caused by the bank’s profit centers, so it’s not like he can tell the Chief Risk Officer, “your job is to only go after good deals and do none of the bad ones.” The CRO doesn’t get to choose the deals, they just get to say “no” to the ones that seem like the worst. What if traders brought nine super risky deals to the CRO and the tenth on was Archegos? What do you say then?
What would really cause change is if the risk management function also got paid for the deals that they got brought but the bank didn’t do. Of course, you can’t run a cost center paying people to not do stuff. They’ll just say “no” to all the stuff. What would help is keeping track of who brought what deals, building a book of counterfactual trades and looking at them on net. Then when a particularly employee brings a new trade, risk management could get paid for saying, “yeah sure, you’ve had some bad ideas in the past, but we like this one,” or inversely “uh no, you’ve had some good ideas in the past, but we don’t like this one.”
Cyber Landscape
The hacking universe used to be populated by romantics. Early internet pioneers had a utopian vision. The internet was conceived of by government and academic institutions as a portal for the free flow of information, a decidedly free speech position in contrast with the Soviet authoritarian model. Whether or not it was a deliberate attempt to undermine the Soviet Union is unclear and irrelevant, what is clear is that the project aligned with U.S. values and goals. The first acolytes, however, were not gmen (and women), but cyberpunks, ex-hippies and counterculture libertarians. This ethos is encapsulated in the essay The Californian Ideology.
By the mid 1990’s the internet was becoming commercialized. Like other frontiers, early settlers were outsiders who fled to escape established hierarchies, but just like other frontiers, they were followed by opportunists seeking social mobility and economic opportunity. This new citizen of the net didn’t always get along with the ex-hippie types, but for the most part the first wave adopted neoliberal values as described in Two decades of the web: a utopia no longer. Utopias only exist in the imagination, so to some extent this was inevitable, but the pace of this evolution, enabled by the lack of physicality of the internet, meant the exploration phase was shorter lived than for most frontiers.
Two successive waves swept the frontier following commercialization, counter-evolution and corporatization. On the one hand, legacy corporations began to adopt digital strategies to prevent disruption, and on the other, a new class of hackers, criminals and civil rights activists fought to maintain the freedoms and permissionless innovation the frontier had afforded.
Cybersecurity, once a backwater of idealogues and national security professionals, became a big business and since then the budgets have grown at an astonishing compounding rate of growth. Bloomberg is predicting total annual cybersecurity spending will exceed $200B by 2024. If cybersecurity were a country, its annual GDP (a better comparison than market caps) would be 51st out of 192 countries in the world, bigger than Iraq and just shy of Greece.
Although it has taken longer than I expected, the growing prominence of the industry is finally drawing the serious attention of legislator and regulators. U.S. Senator Mark Warner is proposing new reporting requirements and organizations to manage this information akin to the National Transportation Safety Board, which was formed in 1967 in response to the growth of the aeronautics industry. As a public good, cybersecurity is non-rival and non-excludable, so it naturally falls to government to provide it, but the problems are now global in scope and there doesn’t seem to be an international body that is interested or able to provide global security.
Deterrence, as discussed above, isn’t all that effective at preventing crime, and the difficulty of attribution online makes this an even greater issue. While more funding and new regulations are helpful, more of the same is unlikely to provide a solution. Greater mindfulness, new wisdom and steadfast devotion will have to be applied to find alternatives as the tools we have today produce lower marginal returns with each additional dollar and every new piece of regulation.
Cyber PE
The ever increasing cybersecurity costs of doing business are not news to private equity companies, which have insight into the income statements across a whole portfolio companies. Buyout giant KKR has held a stake in cybersecurity training company KnowBe4 since at least 2019. KnowBe4 IPO’d recently at a market cap of $3.5B.
Perennial cybersecurity investor, Thoma Bravo, which has also held stakes in SolarWinds, Venafi, Veracode and more, recently completed the take private of ProofPoint, a cybersecurity firm with a long history that has had products in the spam protection, e-discovery and data loss prevention space.
One feature of the cybersecurity industry is that trust, longevity and scale are all strong competitive moats. Venture capital has been pouring into the industry, and while there are plenty of winners, the market dynamics often put superior point solutions at a distinct disadvantage. Meanwhile, mature firms can reinvent themselves, acquire IP and grow their platform to increase revenue, without a substantial increase in fixed costs. An injection of fresh capital and a new strategy is sometimes all they need to do so.
Rockets and Missiles
Another industry that does well in an arms races is, well... arms. As geopolitical tensions rise in Southeast Asia, defense contractors are winning contracts with the U.S. and Australian Navies for long range anti-ship missiles. More long range projectiles require more sophisticated communications networks to produce and manage information. Both defense and intelligence are upgrading satellite communications platforms as phase two of the SatCom rollout begins.
Napoleon, the first military commander to fully embrace projectile warfare, trained as an artillery commander and was also an expert intelligence gatherer and propagandist. When waging long range war, it’s important to have a mental model because you can’t always see your target. Removed warfighting naturally leads to the acknowledgement of propaganda primacy. It’s good to win battles without risking an infantry or cavalry charge, but it’s best to win them without physical expense at all.
Satellites and Space
Maintaining an informational edge, however, is not as cheap as it used to be. Low-latency and redundancy can be a tactical advantage in war, but there are also spillover benefits in civilian technology. Low earth orbit (LEO) satellites provide both faster uplink times and are cheaper to launch. Now these benefits are coming to satellite internet consumers as the FCC approved Starlink’s low orbit satellites.
Finally, another type of space is opening up, 175 million long dormant IP addresses owned by the Pentagon suddenly sprung to life this year, and nobody knew why. The mystery hasn’t exactly been solved, but the DoD answered some questions, including providing a rationale. In an effort to prevent unauthorized use of the IP space the Department claimed it had handed over the addresses to be managed by a previously unheard of company.
Gratitude
Big thanks to Stephen Lyng, Matt Levine, Doug Madory and many others for sharing your ideas that helped me write this piece!