Diablo 3: A Case Of Virtual Hyperinflation

Tyler Durden — Wed, 22 May 2013 02:34:32 +0000

Submitted by Peter C. Earle via the Ludwig von Mises Institute,

As virtual fantasy worlds go, Blizzard Entertainment’s Diablo 3 is particularly foreboding. In this multiplayer online game played by millions, witch doctors, demon hunters, and other character types duke it out in a war between angels and demons in a dark world called Sanctuary. The world is reminiscent of Judeo-Christian notions of hell: fire and brimstone, with the added fantasy elements of supernatural combat waged with magic and divine weaponry. And within a fairly straightforward gaming framework, virtual “gold” is used as currency for purchasing weapons and repairing battle damage. Over time, virtual gold can be used to purchase ever-more resources for confronting ever-more dangerous foes.

But in the last few months, various outposts in that world — Silver City and New Tristram, to name two — have borne more in common with real world places like Harare, Zimbabwe in 2007 or Berlin in 1923 than with Dante’s Inferno. A culmination of a series of unanticipated circumstances — and, finally, a most unfortunate programming bug — has over the last few weeks produced a new and unforeseen dimension of hellishness within Diablo 3: hyperinflation.

Austrian Economics and Inflation

In casual use, the term “inflation” is used in conjunction with price increases. From the perspective of the Austrian School of economics, though, that phenomenon is a secondary effect of increases in the money supply. As Henry Hazlitt wrote,

When the supply of money increase[s], people have more money to offer for goods. … Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A “price” is an exchange ratio between a dollar and a unit of goods. When people have more dollars … [goods] rise in price, not because [they] are scarcer than before, but because dollars are more abundant.[1]

Furthermore, inflation is not simply an increase in the supply of money within an economy; it is the increase in that portion (if any) not backed by a commensurate increase in specie: most common in history, market commodities like gold or silver. Thus fiat currencies are, unless tightly controlled as to the amounts being created versus being destroyed (with the latter typically only occurring due to wear), notably susceptible to inflation.

As virtual currencies are digitally-created and not commodity-backed — therefore, not particularly dissimilar from real world currencies in this day and age — those such as Diablo 3’s gold are de facto fiat currencies.

Sinks, Faucets, and Inflation

In virtual economies, the primary instruments used to control the money supply are “faucets” and “sinks.” Faucets are ways through which game currency is injected into the game. This generally involve players receiving currency from the game system itself, as opposed to other players. In such situations, the received currency is created anew. Sinks are ways through which game currency is removed from the game. This generally involve players paying currency into the game system itself, as opposed to other players. In such situations, the paid currency is destroyed.[2] Examples of faucets and sinks in Diablo 3 are included below:

Faucets

Drops — When a player defeats a foe, they often receive a reward of virtual gold or a good saleable into virtual gold;
Rewards — The game involves the player undertaking “Acts,” and within each act are a number of “quests.” For completing these, players are typically awarded virtual gold;
Buyers — Players can sell items to “in-game” (computerized, non-human) buyers, receiving virtual gold.

Sinks

Repairs — Over time, a player’s equipment will become damaged in combat and suffers wear-and-tear, requiring periodic restoration from an in-game craftsman in exchange for virtual gold;
Forging — Players pay virtual gold to an in-game blacksmith for weapons;
Rakes — Using the gold auction house costs players both a listing fee and a transaction fee, removing virtual gold from the economy;
Consumables — Players can purchase potions, scrolls, and other items from vendors for virtual gold.

Diablo 3 was rolled out in May 2012, and there seem to have been early concerns among players that gold sinks within the game were insufficient. One site noted,

[M]ost of us (probably including Blizzard) assumed that the Blacksmith would be widely used — he was, after all, the only major gold sink in the game … but dropped items alone selling in the [auction house] have been enough to satiate the appetite [of players] and crafting is … a waste of [gold] when one could easily buy an optimal item from the [auction house] rather than pumping 50 to 170K of gold into [a Blacksmith-crafted weapon.][3]

The establishment by Blizzard of a real money auction house (“RMAH”) alongside a virtual gold auction house in the game provided players with an incentive to both farm the game for real world profits and to pursue arbitrage opportunities. The RMAH was also created, at least in part, to disincentivize players from patronizing third party markets outside the game. Nevertheless, bots — automated game participants whose sole purpose is to farm the game world for items to sell — quickly emerged.

Although its anonymity may make it subject to skepticism, several weeks after the game’s debut a source claimed that there were at least 1,000 bots active 24/7 in the Diablo 3 game world, allegedly “harvesting” (producing) 4 million virtual gold per hour.[4] Most of the gold generated by the ruthlessly productive, rapidly adapting bots found its way to third party vendors in a black market which undercut the prices in the sanctioned, in-game auction houses.

The combined effect of heavy bot activity and insufficient sinks immediately impacted the gold markets, and inflationary pressures were soon apparent. An exasperated player complained in August 2012:

I purchased most of my gear for around 5 mil [gold] early on. I’ve been farming for awhile [and] have saved around 30 million gold [but now] I can’t upgrade the gear I have ... Where is all this money coming from? Why is everything so expensive?[5]

And as in real world economies, the price effects of money inflation often arise unevenly. With gold prices falling, prices began spiking in certain goods. Another player noted with curiosity:

[Y]esterday Fiery Brimstone was 150K, now almost 300K. Each time I hit refresh it seems to be going up a bit[.][6]

Gold Floors vs. Black Markets

The RMAH had minimum and maximum dollar amounts for in-game gold transactions: $0.25 minimum, $250 maximum. Market participants were also limited to dealing in increments of a certain size, called a “stack.” The “stack” was initially set to 100K gold. But as gold prices fell owing to rapidly building supply, the stack size was changed in August 2012 to 1 million. This practice, known as redenomination, is a fairly standard (if cosmetic) method of addressing inflation, but was viewed by some players as tacit devaluation.[7]

If you’re changing the [price] of gold from 0.25 per 100,000 to .25 per 1,000,000 I would like to cancel my gold auctions before you do that. You’re completely shifting the market in less than a day, and those of us that have auctions listed that will be affected by this change cannot cancel them until after the patch hits, which is potentially too late.[8]

To be clear, at the time at which the redenomination was introduced, gold was still trading above the floor rate. But being artificial, caps and floors not only prevent markets from clearing, but give black markets a target to undercut, to say nothing of offering players an opportunity to avoid the 15 percent fee — another intended gold sink — levied upon transactions within the auction house. Another player predicted,

[T]his [change] will likely have 2 effects … [it] could kill the private 3rd party market for gold and hopefully discourage botting … [but] because the real money price of gold is decreasing on the RMAH … [g]old will become cheaper as botters flood the market in an attempt to unload their massive surplus of gold before it becomes absolutely worthless. … This decision will further destabilize the economy [as in the gold auction house] prices shoot from 100,000 gold to 1,000,000 gold … [or] 10,000,000 gold to 100,000,000 gold. … The same would happen if the [Federal Reserve] decided to suddenly release a flood of currency into the U.S. economy[.][9]

By early 2013, the gold price had fallen to the exchange floor set by the game managers — $0.25/million — and players began to show signs of concern. One asked,

[Are] there any plans of lowering the floor of gold[?] … It has been at .25 for about 2 weeks now … should I sell my gold now before it gets lowered?[10]

A Delirium of Stacks

Hyperinflation is the economist’s equivalent of an astrophysicist’s quasar cluster or a marine biologist’s dolphin “stampede”: a rare exhibition of a unique set of circumstances which arise infrequently and are closely studied when they materialize. Such events are exotic enough that they become legendary: many individuals knowing little about monetary policy are aware of the recent outbreak in Zimbabwe, or familiar with the defining instance in the post-WWI Weimar Republic.

Economically, the tipping point in the transformation of inflation into hyperinflation is characterized by a profound drop in the outstanding demand for money: when holders of money expect the supply of money to increase — particularly without any sense of timing, bounds, or other guidance — monetary demand in the present drops in favor of surrendering money for vendibles.

The focus of possessors of money, therefore, devolves into an effort to capture known, present purchasing power against the likelihood of its decline in the near future. Saving, in any event, delaying consumption, is chastened; and if a cycle of declining purchasing power and rapidly rising prices ensues, ultimately the propensity to hold money declines precipitously and may fundamentally disappear.

This was demonstrated when, in a message board entry prefaced by stating “Sell Equipment before Patch 1.0.5 Hits!” (a patch is a piece of software added to an operational program or application as bugs are found, changes desired, or ways of improving performance discovered), a player warned that,

Blizzard just announced that the drop rates for [certain] items are going to be doubled … if you haven’t already, you should consider converting your current gear to cash … since real $ [are] the best hedge against gold devaluation[.][11]

If historical cases of hyperinflation — real, and now virtual — have one thing in common, it is the instinct among its victims to blame the symptoms rather than the disease. The Austrian economist Hans Sennholz noted that during the German hyperinflation, “intrigue and artifice” were believed to be at work.[12] Similarly, a handful of Diablo 3 players, frustrated about the decimation of their purchasing power, expressed increasing suspicion of manipulation and conspiracy theories.

[W]hy [are] certain items priced [s]o astronomically high? Many of them are not even that good yet cost 100’s of millions of gold. … I have about 45,000,000 gold saved up [and] check every few days to see if I can get any upgrades that are worth the gold, but … everything is vastly overpriced … clearly controlled by the gold sellers.[13]

And, predictably, any number of baleful remedies were proposed.[14]

While RMAH prices for virtual gold rallied occasionally, the prevailing direction of black market prices for virtual gold was inexorably lower as third party sellers undercut the in-game gold floor. In February 2013, Patch 1.0.7 was rolled out, introducing a range of new gold sinks intended to sop up ever-increasing virtual gold; they included new weapons and items not eligible for sale on the RMAH. One month later, with gold prices continuing to decline, a player made the following diagnosis:

[A]dditional gold sinks [are] unfortunately comparable to spitting on a fire ... [they] do nothing to limit the core issue which is that players are earning gold faster than they [want] to spend it. Repairing is not a … good gold sink as it works best [for] players who are [dying]. … Crafting is the same, works well on players who can get the items to craft with … but leaves players with limited gold supply out of the picture. … The amount of gold that drops … needs to be nerfed, and not softly.[15]

The effort appears to have been futile, as the growth of the virtual gold supply continued to grow.

Several competing definitions for hyperinflation exist, with the strictest — an increase of 50 percent in one month — defined by economist Philip Cagan in his 1956 book The Monetary Dynamics of Hyperinflation. By his definition, the Diablo 3 economy appears to have entered hyperinflation between February and March of 2013, when the black market price of gold fell from $0.20/million to $0.05/million — a decline of over 75 percent in a few weeks. At around that time, a player commented that he was

watching the markets collapse and gold become worthless. … So you feel rich that you have a billion or two in gold[?] … [W]ell guess what, you aren’t … there is nothing you can invest in to hold value. The only thing worth anything has become $$$.

With a sardonic irony that markets sometimes display, real world currencies had assumed the role of commodity gold, and virtual gold had gone the way of all flesh and fiat currencies.

This, however, was still only the penultimate stage. On May 7th 8th, 2013, Blizzard rolled out Patch 1.0.8, which contained the seeds of the last, hyperbolic surge of gold superabundance. One change was the altering of the gold stack size from 1 million to 10 million per $0.25: a simultaneous redenomination and 90 percent devaluation (sitting, as the price was, at the RMAH floor) of virtual gold, targeting black market rates of roughly 4 cents per 10 million. In addition, a bug within the patch allowed users to cancel transactions in the auction house before completion, essentially allowing them to double their gold on demand.

In just a few hours, the already gold-swamped economy saw trillions more created: a mammoth deluge of, by then, worthless virtual gold chasing finite goods, driving prices upward in leaps and bounds. It was, at last, the hyperbolic blow-off characteristic of real world hyperinflationary episodes. Some of the price increases (in Diablo 3 gold) are shown below:

	2013 avg price	1-6 May avg price	7-8 May price
radiant star amethyst	17.4M	41.2M	85.8M
radiant square ruby	187K	260K	337K
flawless square topaz	491	5,170	8,700
star emerald	764K	1.1M	1.6M
tome of jewelcrafting	694	3,400	3,100

And in a noteworthy departure from real world hyperinflation, rather than resorting to barter (which frequently takes the form of food for skilled labor), as runaway inflation became hyperinflation, many chat channels — through which some measure of trade was consummated — seem to have fallen empty: without a need to eat or clothe oneself in the virtual world, some players simply appear to have turned away

Aftermath

Blizzard quickly closed the in-game auction houses and audited transactions which took place during the blowout, banning players who took advantage of the bug and donating the proceeds of certain sales to charity. The gold stack size was also moved back from 10M to 1M. One week later, on May 15th, the above-cited items were quoted at the following, approximate virtual gold prices: radiant star amethyst, 26.1M; radiant square ruby, 375K; flawless square topaz, 8,600; star emerald, 797K; tome of jewelcrafting, 1,350.

In May of 2012, the price of virtual gold was approximately $30/100,000 or $0.0003/gold. As this article was completed — and bearing in mind that these prices may be erroneous, stale, or merely indications of interest — one site showed Diablo 3 gold being offered by four third party sellers at an average price of $1.09/20M, or $0.0000000545/gold: one ten-thousandth its market price one year earlier.In the RMAH, virtual gold was priced at $0.39/1M.

Remembering that game economies are private and players are voluntary members, there’s no explicit mandate to ensure rigid inflation control as one often sees (however rarely pursued) in public economies. That said, knowing that gaming experiences can be upended by economic missteps, there is a clear business interest for gaming firms in keeping virtual currencies and the greater economies as a whole stable.

Frequently, hyperinflationary episodes have ended by substituting a currency outside the political and central banking control of a nation for the sovereign currency. During the early 1990s, during Serbia’s hyperinflation,

[t]he authorities could not print enough cash to keep up. On Jan 6th, 1994, the dinar officially collapsed. The government declared the German mark legal tender … [which] end[ed] the hyperinflation.

Two obvious solutions for managers of virtual economies include more vigilant bot restrictions and close — indeed, real-time — monitoring of faucet output, sink absorption, prices, and user behaviors. More critically, though, whether structured as auctions or exchanges, markets must be allowed to operate freely, without caps, floors, or other artificialities. Unrestricted (real) cash auctions would for the most part preempt and obviate black markets.

One also surmises, considering the level of planning that goes into designing and maintaining virtual gaming environments, that some measure of statistical monitoring and/or econometric modeling must have been applied to Diablo 3’s game world. The Austrian School has long warned of the arrogance and naïveté intrinsic to applying rigid, quantitative measures to the deductive study of human actions. Indeed; if a small, straightforward economy generating detailed, timely economic data for its managers can careen so completely aslant in a matter of months, should anyone be surprised when the performance of central banks consistently breeds results which are either ineffective or destabilizing?

By no means does this analysis intend to equate the actions of virtual gaming firms with the policies of governments or central banks, or to malign their indisputably talented managers, designers, and programmers. While their actions may ultimately generate similar outcomes, central planners seek and wield power whereas the actions of commercial gaming interests are undertaken to compete with other online entertainment providers by delicately balancing opportunities for newer players with the need to continually challenge experienced players.

By all accounts Diablo 3 is a great game; one hopes that with this episode passed, it will reacquire its former glory. But while decision-makers at online gaming firms can and should be forgiven for not anticipating the perilous and unpredictable torsions of rapidly expanding money supplies, the events of the last week provide a stark reminder of the power and inescapability of the laws of economics.

Visualizing The Cost Of Mining Gold

Tyler Durden — Wed, 22 May 2013 01:59:56 +0000

There are over 3 billion ounces of gold in the world's deposits. The Top 50 of these mines alone contain over one-third of the total gold. North America is the 'cheapest' place to produce gold and Africa the most expensive. Gold producer profits are getting squeezed from both directions: lower gold prices and rapidly inflating costs...

The Pentagon Admits: The "War On Terror" Will Never End

Tyler Durden — Wed, 22 May 2013 01:26:12 +0000

Submitted by Michael Krieger of Liberty Blitzkrieg blog,

It is hard to resist the conclusion that this war has no purpose other than its own eternal perpetuation. This war is not a means to any end but rather is the end in itself. Not only is it the end itself, but it is also its own fuel: it is precisely this endless war – justified in the name of stopping the threat of terrorism – that is the single greatest cause of that threat.

- Glenn Greenwald from his recent article: Washington Gets Explicit: Its “War on Terror” is Permanent

So last Thursday at a hearing held by the Senate Armed Services Committee, we found out what many of us already knew. That the “war on terror” is never going to end. Indeed, it was never supposed to end. This never-ending “war” on a fantastical enemy provides the American oligarch class with too much money and too much power to ever make it worthwhile for the establishment to shut down. It matters not to them that this civil liberties destroying fraud has been going on for my entire post-college life and, if they have their way, for the remainder of it. It matters not to them that the “war on terror” itself has done more to destroy the Constitution and vital essence of this nation than any terrorist act ever could. No, it matters very little indeed. What matters to them is money and power, and the “war on terror” provides them with boatloads of both.

My favorite excerpts from Glenn’s article are below:

On Thursday, the Senate Armed Services Committee held a hearing on whether the statutory basis for this “war” – the 2001 Authorization to Use Military Force (AUMF) – should be revised (meaning: expanded). This is how Wired’s Spencer Ackerman (soon to be the Guardian US’s national security editor) described the most significant exchange:

“Asked at a Senate hearing today how long the war on terrorism will last, Michael Sheehan, the assistant secretary of defense for special operations and low-intensity conflict, answered, ’At least 10 to 20 years.’ . . . A spokeswoman, Army Col. Anne Edgecomb, clarified that Sheehan meant the conflict is likely to last 10 to 20 more years from today – atop the 12 years that the conflict has already lasted. Welcome to America’s Thirty Years War.”

That the Obama administration is now repeatedly declaring that the “war on terror” will last at least another decade (or two) is vastly more significant than all three of this week’s big media controversies (Benghazi, IRS, and AP/DOJ) combined. The military historian Andrew Bacevich has spent years warning that US policy planners have adopted an explicit doctrine of “endless war”. Obama officials, despite repeatedly boasting that they have delivered permanently crippling blows to al-Qaida, are now, as clearly as the English language permits, openly declaring this to be so.

It is hard to resist the conclusion that this war has no purpose other than its own eternal perpetuation. This war is not a means to any end but rather is the end in itself. Not only is it the end itself, but it is also its own fuel: it is precisely this endless war – justified in the name of stopping the threat of terrorism – that is the single greatest cause of that threat.

In response, I wrote that the “war on terror” cannot and will not end on its own for two reasons: (1) it is designed by its very terms to be permanent, incapable of ending, since the war itself ironically ensures that there will never come a time when people stop wanting to bring violence back to the US (the operational definition of “terrorism”), and (2) the nation’s most powerful political and economic factions reap a bonanza of benefits from its continuation. Whatever else is true, it is now beyond doubt that ending this war is the last thing on the mind of the 2009 Nobel Peace Prize winner and those who work at the highest levels of his administration. Is there any way they can make that clearer beyond declaring that it will continue for “at least” another 10-20 years?

And then there’s the most intangible yet most significant cost: each year of endless war that passes further normalizes the endless rights erosions justified in its name. The second term of the Bush administration and first five years of the Obama presidency have been devoted to codifying and institutionalizing the vast and unchecked powers that are typically vested in leaders in the name of war. Those powers of secrecy, indefinite detention, mass surveillance, and due-process-free assassination are not going anywhere. They are now permanent fixtures not only in the US political system but, worse, in American political culture.

Each year that passes, millions of young Americans come of age having spent their entire lives, literally, with these powers and this climate fixed in place: to them, there is nothing radical or aberrational about any of it. The post-9/11 era is all they have been trained to know. That is how a state of permanent war not only devastates its foreign targets but also degrades the population of the nation that prosecutes it.

This war will end only once Americans realize the vast and multi-faceted costs they are bearing so that the nation’s political elites can be empowered and its oligarchs can further prosper. But Washington clearly has no fear that such realizations are imminent. They are moving in the other direction: aggressively planning how to further entrench and expand this war.

Newly elected independent Sen. Angus King of Maine said after listening to how the Obama administration interprets its war powers under the AUMF:

This is the most astounding and most astoundingly disturbing hearing that I’ve been to since I’ve been here. You guys have essentially rewritten the Constitution today.”

Former Bush DOJ official Jack Goldsmith, who testified at the hearing,summarized what was said after it was over: Obama officials argued that “they had domestic authority to use force in Mali, Syria, Libya, and Congo, against Islamist terrorist threats there”; that “they were actively considering emerging threats and stated that it was possible they would need to return to Congress for new authorities against those threats but did not at present need new authorities”; that “the conflict authorized by the AUMF was not nearly over”; and that “several members of the Committee were surprised by the breadth of DOD’s interpretation of the AUMF.” Conveying the dark irony of America’s war machine, seemingly lifted right out of the Cold War era film Dr. Strangelove, Goldsmith added:

Amazingly, there is a very large question even in the Armed Services Committee about who the United States is at war against and where, and how those determinations are made.”

Nobody really even knows with whom the US is at war, or where. Everyone just knows that it is vital that it continue in unlimited form indefinitely.

1984 really was an instruction manual for the people in power. Terrifying.

So You Want To Work In JPMorgan's Legendary Gold Vault? This Is Your Chance

Tyler Durden — Wed, 22 May 2013 00:51:52 +0000

For all those whose lifelong ambition has been to work with the recently reappointed joint Chairman/CEO of JPMorgan in the firm's legendary and infamous gold 'clearing' operation (whose formerly classified New York, the largest in the world, and London vault locations were exposed here and here), today is your lucky day:

But more important than what the firm is looking for, is what is willing to provide. Information. Such as:

JPM currently holds a 45 % market share of the London Clearing: not quite a monopoly but close enough
The London clearing transacts approx $ 40 bn value in metal transfers each day on behalf of participants in the London market
It conducts Location swaps: literally, what it sounds like
The firm has consignment agreements in India, China, Thailan, and... Turkey: the infamous gateway to Iran?
The firm's gold clearing and physical desk engages in liquidity management between London, Zurich and... the Bank of England?

h/t Ro

"The Math Is Stacked Against Japan - It's Not 'If', It's When"

Tyler Durden — Tue, 21 May 2013 23:40:05 +0000

As the BoJ prepares to thrill us with even moar in its latest policy meeting (or not as we discussed earlier) and with Amari et al. now jawboning JPY to some extent to control the out-of-control chaos in JGBs, it is perhaps worth taking 20 minutes to comprehend just what all this extreme policy action means. The following brief presentation covers it all in a Kyle-Bass-ian facts-and-fallacies manner, Christine Hughes sums it all up perfectly, for Japan, "The Math Is Stacked Against Japan - It's Not 'If', It's When."

Global Assured Destruction, Or How Bernanke Now Holds The Entire World Hostage

Tyler Durden — Tue, 21 May 2013 22:49:05 +0000

The one headline we have been waiting for for over four years has just hit:

BOK KIM SAYS WORLD MAY FACE RATE RISK IF U.S. EXITS FROM QE

Not when, if. And there you have it: if the Fed exits, the world (and most certainly Japan) gets it. Thus, for the sake of the children (who will have inhert about $100 trillion in debt but don't worry: debt is an asset as some "analysts" will promise) Bernanke can never exit. QE...D

And since never is a litte longer than 2016/2017, at some point in the next few years Bernanke will be the proud owner of all marketable Treasury paper. All of it.

How To Arbitrage The People's Bank Of China

Tyler Durden — Tue, 21 May 2013 22:39:15 +0000

Since there are now numerous hard proofs that China’s export data (and to some extent import data as well) were significantly distorted recently, we naturally wonder the incentives behind the distortion and the detailed mechanism of these manipulations. As BofAML notes, there are four reasons why the distortions have risen so sharply since Q4 2012 but the various arbitrages (described in actionable detail below) between onshore and offshore currencies and interest rate differentials (and the role of gold in this) remain in place to make judging China's real trade growth as much art as science.

Via BofAML,

In the starting period of using RMB for trade settlement (2010-2011), people might not learn the trick on how to benefit from the differential between CNH and CNY exchange rates. And the differential was quite small before October 2012 when markets perceived a significant RMB/USD depreciation. Only since 4Q12 several preconditions were ripe for massively manipulating trade data.

First, RMB/USD started appreciating again.
Second, the China’s economic growth started rebounding. These two preconditions made it attractive to bring in hot money via over-reporting exports.
Third, the differentials between CNH/USD and CNY/USD got widened in 4Q12 with CNH/USD becoming more expensive than CNY/USD, making it’s profitable to do arbitrage (more details below).
Fourth, people were experienced enough to use RMB trade settlement to carry out relatively complicated arbitrage.

Arbitrage the CNY-CNH exchange rate differentials

Demand for RMB assets in offshore markets has picked up since 4Q12 on a better growth outlook and the introduction of new investment tools such as RQFII, causing CNH/USD (RMB traded offshore) to be more expensive than CNY/USD (RMB traded onshore). At the peak in January, CNH was 0.6% more expensive than CNY. Consequently, arbitrage opportunities between CNY and CNH arise if people can manage to bring CNY to offshore RMB centers like Hong Kong. The trick is seemingly complicated, but actually the arbitrage is quite simple. Let’s use an example to reveal the mechanism of this arbitrage.

1. In mainland China, an arbitrager could borrow US$1.0mn and convert to CNY at exchange rate 6.20 (so he gets RMB6.2mn);

2. He could import something with minimum transportation costs such as gold from Hong Kong and settle the imports with the borrowed RMB6.2mn. In this way, this RMB6.2mn flows to Hong Kong and becomes CNH;

3. He then instructs his business partners (or his Hong Kong subsidiaries) to converts the RMB6.2mn to USD in HK. Assuming USD/CNH is 6.15, he gets US$1,008,130;

4. Finally he exports the previously imported gold which is settled in USD. In this way, US$1,008,130 flows into mainland China and the arbitrager completes the whole deal with a profit at US$8130 (perhaps less than that due to some transport and custom fees).

Arbitrage the differentials between CNH and CNY interest rates

Another arbitrage can gain purely from the interest rate differentials between CNH and CNY. Note interest rates for RMB are different onshore and off-shore. An arbitrager can gain by borrowing CNH at low rates, converting CNH to CNY and depositing CNY at higher rates. Currently the spread could be around 70bp. Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks (the time needed for getting CNH loans in Hong Kong), he then deposits RMB1.0mn in a bank with deposit rate at 3% and ask the bank to issue L/C for him;

2. With the L/C, his Hong Kong partners could get RMB1.0mn loans from HK bank for one year. The arbitrager then export something with minimum transportation costs to Hong Kong and the RMB1.0mn is sent to mainland China. He repays the RMB1.0mn.

3. His profit is calculated as follows. The revenue is the differential between the onshore RMB deposit rate and the offshore RMB financing costs. Currently the spread is around 70bp after deducting related costs, so the revenue is RMB7000. His cost for borrowing RMB1.0mn for one month is 2500. So his risk-free net return is RMB4500.

Arbitrage on interest rates differential and RMB appreciation

The most complicated arbitrage can gain from RMB appreciation, the interest rate differentials between onshore RMB and offshore USD, and the differential between CNH/USD and CNY/USD. Note that 1yr RMB deposit rate in China is now 3.0% but 1yr dollar lending rate in HK is lower than 2% (LIBOR +100bp). Here is an example on how to carry out this arbitrage.

1. In mainland China, an arbitrager borrows RMB1.0mn at a rate of 6% for two weeks, he then put RMB1.0mn as 1yr time deposits in a bank at 3% and ask the bank to issue L/C for him;

2. Assume USD/CNH is 6.15. With the L/C, his Hong Kong partners could get 1yr dollar loans of US$162,602 (=1000,000/6.15) at 2% from a HK bank.

3. The arbitrager then exports something with minimum transportation costs to Hong Kong and the US$162,602 is sent to mainland China. Assuming USD/CNY is at 6.2, he can get RMB1,008,132. He repays the original RMB loan at the amount of RMB1002,500 (RMB2,500 is interest payment) and obtain an immediate profit at RMB5632 which he will also put in 1yr deposit.

4. One year later, his time deposits will be valued at RMB1,035,801 (with interest payment). Assuming CNY/USD appreciated 2%, he can convert his this to US$171,774.

5. He imports the goods from Hong Kong he exported a year ago by paying US$165854 (=162602*1.02). In this way he moves US$165854 to HK to repay his loans (principal plus interest payment).

6. His net profit (in one year) is US$5920.

Outright hot money inflow

In the above three cases of arbitrage, the person could even raise prices of exports which were previously imported to bring in hot money. When people believe the Chinese economy is safe (especially as growth recovers) and CNY/USD will appreciate, they have the incentive to take in hot money to benefit from higher interest rates in China (than USD rates) and CNY/USD appreciation.

Beware These Unseen “Friction” Costs!!

Capitalist Exploits — Tue, 21 May 2013 22:16:31 +0000

Brokers, placement agents, middle men, promoters, consultants, financial intermediaries…call them whatever you wish. They have existed in the financial space since man invented a way to exchange one thing of value for another.

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Some do a fine job, provide a valuable service and deserve every penny they earn. In my experience however, and that of Mark and many of our friends who invest in private equity, these people, the deserved ones that is, are a very small fraction of those inhabiting this space. I’ve met hundreds of middle men and can count on one hand those I trust and value.

In the private equity space they are abundant. MAN are they abundant. In fact, I think we currently have a bubble in middle men. Doubt me? Hop onto LinkedIn and you’ll find every Tom, Dick and Sheryl hard at work putting Nigerian scam artists to shame. To be fair, they may represent real deals which in-and-of-themselves are not shams, but beware the costs. Many “represent” millions in capital, yet like those “trusty” Nigerians, who also represent gobs of dough, somehow they just need that little itty-bit of additional capital from you and I to “pull it over the line.”

I bring this up because of an amusing interaction I had recently with one such individual. I’d like to think that shining a light on some of these creatures lurking under slimy rocks may help other investors recognize these clowns when they see them. It may also serve as one of the red flags I previously spoke about for investors seeking an entrance into private equity deals.

Firstly, you’ll likely have already come across some of them; they’re quite possibly the guys “endorsing” you for your skills on LinkedIn. WTF..?

I’m confused, some guy I’ve never met and don’t know from Adam, just endorsed me for “Strategic financial planning” skills. As confusing as this is, what really gets me is why I’ve not been endorsed for my great pancake making skills. My kids reckon I’m the best there is, and they actually know me and have witnessed said incredible pancake making abilities. The guy on LinkedIn…not so much!

Now these guys are nothing like brokers at all, but rather more akin to back alley abortionists peddling their wares, complete with the rusty, blood-stained “tools” from the last botched job. They litter the world of private equity like plastic bags on a Maputo high street, and frankly annoy the sh*t out of Mark and I.

A story to illustrate absurdity…

Onto my tale. I was recently put in touch with a gentleman of the type I described above, it turned into the stuff of high comedy.

Now, the underlying business was actually OK, which was why I gave the time of day to him to further explain the deal terms. However, the structure of the deal was such that the “promoter” got a fat chunk of the cash out of the gate, travel expenses (which were obscene), and sundry other expenses, which I showed to Mr. back alley boy, that amounted to fully 60% of the investors capital! I kid you not! Even more amazing to me is that this clown had in fact already found an investor of sufficiently low intellect to invest in the deal, taking out the majority of the offering. A 7-figure sum. I pity the sod. Something about “fools and their money” comes to mind.

This particular investor now requires a 150% return in order to simply break even. This, on an investment which is high risk to begin with, and where it’s entirely possible to lose 100% of his money. Of course the promoter was doing his damndest to make the deal sound like a low risk, HUGE upside, fit for widows and orphans opportunity. He tried to weasel his way out of the facts when I presented them to him, but I was having none of it. In frustration he simply walked away saying I didn’t understand the deal. Oh, I understood…and that of course was the problem.

This was one of the more extreme cases I’ve seen of friction costs, but I will say that it’s pretty common for your investment dollar to be “attritioned” or “frictioned” to the tune of 15% or more on many deals I’ve reviewed. On a $100,000 placement you’re looking at losing $15,000 right out of the gate if you don’t pay attention.

You will almost NEVER be shown these details, but will need to closely examine the deal to find them out. Small print etc. folks. Look for font size 8 and read diligently.

As an investor it’s crucial to understand the cost of capital for any business you are looking at getting involved in. Additionally, ferreting out the true cost of capital for a business, and whether you are getting hosed or not, is important in order to understand the true state of accounts in the company.

Some points:

Find out how much capital hits the balance sheet. Unless its a “friends and family” round you’ll likely have placement fees somewhere. No problem, but analyze them and make sure that they make sense.
Always ask whether they have their own capital on the line, how much, and ask for proof and full disclosure of compensation to those involved in the transaction. Let me tell you there is a vast, Grand Canyon wide difference between having your own cash on the line and that of a client, friend, associate, or whatever you want to call “the other guy”… you know, the one who is actually putting up the capital.

Kyle Bass mentions the, “give a shit factor”, and it is remarkably high when putting your own cash on the line. I should know, I’ve been “dumb enough” my entire adult life to be the guy putting his own capital to work and only getting paid when I’m right, and taking it on the chin when I’ve screwed up. It has frustrated me many times to have watched middle men walk away with larger sums than I…even after they never put a single dime on the line. No need to follow my path though, you can always become a mini-Bankster yourself.

Good luck out there, watch ceaselessly for this nonsense and make sure you ask the question first and foremost if any fees are being paid and to whom. Full disclosure should be given. So, next time some back alley abortionist lies to you, do us all a favour and punch them in the face.

- Chris

“Money talks and bullsh*t walks” – Sam Zell

Bank of Japan Policy Meeting Preview - Chance Of A Bond Crash?

Tyler Durden — Tue, 21 May 2013 21:58:58 +0000

Excerpted via Bill Blain of Mint Partners,

The current Bank of Japan policy meeting is possibly the most important thing going on this week (even more so than Bernanke's comments perhaps). If, as is distinctly possible, they don’t do anything to reinforce the immediacy of the Kuroda QQE package, we could be looking at bond markets reacting in a most "unfavorable manner". The effect would be to reinforce the latest round of 'fear-on' bond selling – certainly over the short-term, and the damaged sentiment could impact stocks also.

...

That's why the Bank of Japan policy meeting today/tomorrow will be so interesting. Can it nurture and sustain real growth? Devaluing yen to benefit exporters does seem to be working - look at recent Yen corporate results. However, now we've got the rest of Asia looking to balance Japan's competitive devaluation. We still need to see how the other side of Abe-onomics works: rebuilding Japan. How vulnerable is the BoJ game? The Nikkei may be massively higher, but interest rates and JGB's remain stubbornly volatile and high - a factor conflating the global bond worries... if the Fed is going to end QE and Japan's QE squared isn't working, then bond players will quite rightly capitulate.

There is probably not much the BoJ can say at this meeting – it’s got to give the policy (of massive QE) time to work. That leaves markets highly vulnerable to a sense of disappointment tomorrow. On the other hand, we've long said.. "Don't fight Kuroda!"

...

Whatever happens in the Japan story; how much longer the Fed keeps up the buying, and the implications on Global QE remain the main themes and drivers of the current market. The question is, for how long might markets be put on the back foot by the continued weakness in JGB and knock on effects. [let alone Europe]

...

Back in the bond market, over the last few days the search for yield does seem capped. There have been some stumbles in new issues, and we're encountering reluctance from buyers to engage some excellent client offers for the highest yielding names like Greece or Slovenia. We've seen limited interest in relative spread trades - for instance privately placed Canada risk at a significant spread over the underlying provincial names. That all tells me the bond market is nervous.

IRS' Lois Lerner To Plead The Fifth Before House Oversight Committee

Tyler Durden — Tue, 21 May 2013 21:32:42 +0000

For an affair that numerous media outlets will have you believe has been spun out of all proportion, and that it really is the conservatives fault that the IRS was targeting them, it is somewhat ironic that the IRS official who opened up the entire Pandora's box with her targeted apology two weeks ago, and who learned in 2011 about the improper targeting of political groups yet lied under oath to Congress to the contrary, has decided to plead the Fifth and will invoke her right not to testify on Wednesday for fear of self-incrimination, according to her lawyer. But this would mean that... she may have something to hide? And that would be rather problematic for the media's spin cycle, although we are confident it will take just a few minutes of deep though in the proper channels, before this all too overt admission of guilt is somehow spun as the IRS being the unwitting targets of an aggressive McCarthyesque campaign seeking to discredit the government's impartial tax collector whose only noble purpose is to enable the government to get even bigger.

From the LA Times:

Lois Lerner, the head of the exempt organizations division of the IRS, won’t answer questions about what she knew about the improper screening — or why she didn’t disclose it to Congress, according to a letter from her defense lawyer, William W. Taylor III. Lerner was scheduled to appear before the House Oversight Committee on Wednesday.

“She has not committed any crime or made any misrepresentation but under the circumstances she has no choice but to take this course,” said a letter by Taylor to committee Chairman Darrell Issa (R-Vista). The letter, sent Monday, was obtained Tuesday by the Los Angeles Times.

Perhaps she could clarify what circumstances those are: maybe the same ones that forced her to bow out of the Western New England Law School commencement speech?

Taylor, a criminal defense attorney from the Washington firm Zuckerman Spaeder, said that the Department of Justice has launched a criminal investigation, and that the House committee has asked Lerner to explain why she provided “false or misleading information” to the committee four times last year.

Since Lerner won’t answer questions, Taylor asked that she be excused from appearing, saying that would “have no purpose other than to embarrass or burden her.” There was no immediate word whether the committee will grant her request.

Wait, criminal investigation? Does this mean that the administration will offer yet another deferred-prosecution deal whose terms will involve harsh mandatory lifetime pensions and onerous full benefits upon retirement? Surely not even a corrupt, co-opted, drenched in scandals administration is that inhumane.

And on that note, we leave you with...