What Range can teach us about risk: Crypto Political Risk; AttentionWare; Uncorrelated Returns; Federalism
... Progress on a broad front results from the free play of free intellects, working on subjects of their own choice...
- Vannevar Bush
Risk Developments this letter:
Crypto Political Risk
Specialization has its benefits. Winning the software engineering tournament can yield a high salary, deep expertise can give you an edge in investing and specialized knowledge (whether in business, technology or international affairs) can unlock secrets that give you an unfair advantage. The flip side of specialization is the lack of optionality. As a highly paid software engineer, there are only a dozen or so companies that can afford you. As an investor, your circle of competence is narrowed to specific industries. As a knowledge worker, it may lock you in to an increasingly irrelevant mission.
From time to time we talk about variousdefinitions of risk. One definition of risk might be, “the inability to walk away from a bad situation.” David Epstein’s “Range” makes the case for generalists, emphasizing advantages such as creativity, agility and the ability to make disparate connections. Being able to cut one’s losses may seem like a counterintuitive key to good risk management, but it is fundamentally the source of real option value.
The setup of “Range” begins by examining the popular 10,000 hour rule and looking at professional athletes, scientists and forecasters at the top of their game. Specialization works well in a static environment, when the inputs, outputs and objectives are not shifting, but Epstein finds that behind many stories of intense focus and deliberate practice are actually divergent thinkers willing to engage in radical self criticism and, most importantly, acknowledge when something isn’t working.
After dispensing with the myth of the single minded savant, Epstein uncovers the benefits of generalists.
“... The most effective leaders and organizations had range; they were, in effect, paradoxical. They could be demanding and nurturing, orderly and entrepreneurial, even hierarchical and individualistic all at once. A level of ambiguity, it seemed, was not harmful. In decision making, it can broaden an organization's toolbox in a way that is uniquely valuable .”
Being able to maintain multiple realities within an organization not only enables the placing of many bets, but it can also further the ability of those bets to pay off. For example, a great athlete may have to choose between two sports to specialize in, but not only do they have a choice, but their experience in one sport may improve the way they play the other.
In the final third of the book, Epstein provides some actionable advice for developing one’s range. The first piece of advice, mentioned above, is being willing to walk away. The second is becoming a deliberate amateur. Free play and curiosity are far more powerful forces than are often recognized. Finally, he concludes, in a nod to the opening critique of deliberate practice, that what often holds us back from fulfilling our potential is the knowledge of how much work it will take to obtain expertise. Many of the most talented people in the world don’t hit their stride until late in life, after becoming experts in a few unrelated fields. The key is not just to walk away from what isn’t working, but also to keep trying in other domains. Specialization isn’t the enemy, but ego is.
Political Crypto Risk
Recently we talked about the spectrum in finance from market to political risk. As Mark Rosenberg points out, cryptocurrency is not a good geopolitical hedge:
Being correlated with political risk, however does not mean that cryptocurrencies are bad news for all governments. For one thing, governments that have already given up sovereignty over currency (those that have adopted the dollar, for example) may find it an attractive hedge. El Salvador made big news accepting bitcoin as legal tender, and although this doesn’t change much for countries with monetary sovereignty, like the U.S. or China, it does provide the potential ability to walk away from the international financial system for countries that have already given up monetary sovereignty.
A related political risk issue in cryptocurrency is the seizing of the Colonial Pipeline ransom by the FBI. Here the U.S. Government proved that cryptocurrencies are not beyond the reach of law enforcement, but for El Salvador, this may be good news. In the short run, it undermines a big, but problematic use case for cryptocurrency, but in the long run the supply of bitcoin remains beyond government control, while regulating its uses for less nefarious activities. The question still remains about activities that one government views as nefarious, but others do not. Cryptocurrency may not be a political risk hedge, but they could be a political risk arbitrage.
Speaking of ransomware, the White House wrote an open letter on the topic. As insurers continue to raise the alarm about the impact of ransomware on the business community and the insurance industry, look for more attention from the government, both to subsidize insurers and reduce losses.
The fight, however, is far from over. While Colonial Pipeline and JBS got lots of press, another pipeline was hit with a ransomware attack that is not getting the same attention. The perennial question about cyber incidents is whether the ones we know about comprise a significant number of the attacks that happen. My hunch is that most attacks come to light over time, but the frequency and inability to quantify impact make most of these stories fly below the radar.
One reason the insurance industry is so fascinating is that under the radar news often does matter in insurance and can have big consequences. Hurricane insurance is a pretty specific niche of the industry, and one that has a vested interest in the slowing of global warming. Compared with the frontal assault on the oil and gas industry, natural catastrophe insurance has been quietly adapting to this risk for decades. A nifty piece of financial engineering called a cat bond (neither bond nor cat related) is a way to securitize catastrophe risks that are too big for any single reinsurer to hold. The news that the Texas Wind Insurance Association was able to double the amount of capital raised with a cat bond is the latest in a story of capital seeking alternative uncorrelated yield.
Berkshire Hathaway Specialty Insurance is one of the savviest investors looking at alternative ways to generate yield and often find themselves in exotic and esoteric risk markets. Now they are getting into French marine insurance. This story is at the nexus of climate, covid and geopolitical issues with the recovery coinciding with the culmination of Brexit and increased demand as few risk takers want in on shipping risk while climate volatility continues to risk. BHSI, however is a generalist, applying their underwriting discipline wherever possible, making moves like this one something to watch.
In other insurance news, the Aon/WTW merger appears to be one step closer to getting approval as Aon plans to sell off assets to private equity firms. Retirement insurance and benefits businesses are politically sensitive, but ripe for purchasing by dispassionate financial sponsors, which should bode well for both insurance, which gets some breathing room from regulators and private equity, which likes buying stable, cash flow producing, businesses at a good price.
Two seemingly unrelated pieces of government news broke last week. First, the State banking regulators’ victory over the OCC for the power to issue fintech charters was overturned. Digital first banks prefer a national charter because they would prefer a national customer base and simplified regulation, but the United States has a peculiar banking industry with lots of regional and local oligopolies, protected by State regulation. Having won round one, it looked as if the industry would stay that way. The downside of greater competition is that fewer big banks means less ability for customers to walk away. This may result in fewer, but more specialized, banks even if there is a short run increase in competition.
The second piece of government news is the Cybersecurity Infrastructure and Security Agency’s new cyber disclosure platform. Biden’s cybersecurity executive order mandates disclosure of breaches and now it is possible. Being able to walk away quietly from cybersecurity incidents has reduced risks for business, while socializing the costs. Now it appears that all companies are going to have to specialize in cybersecurity, or at least centralize that capability in third party providers.
Big thanks to David Epstein, Mark Rosenberg and others for sharing your ideas!