Saturday, March 28, 2009

The Case for the Share Standard – Part I

You all remember the gold standard. Some trogs still push it today as a remedy for so-called “fiat” currency. I think the gold standard invokes a sound premise, even if the actual standard itself fails to make the best use of it.

The premise behind the gold standard is that money is a token of worth. If I own the only piece of gold in the world, and gold is the only thing of value in the world, I can say to a neighbor “If you survey my land, I will give you 1/1000 of my gold, and, rather than burden me with cutting it and you with storing it, I'll just give you a piece of paper that says you can have the gold if you want it. You can give the paper to anyone you want in exchange for something they do for you. And I'll promise to store the gold where you can see that it's there.”

That's money created on the gold standard. My neighbor accepts the paper because he knows I have the gold and that his piece of paper is “convertible” into it at any time. The problem with the gold standard is that I also own my land. Why not promise him a piece of the land? Well, it's awkward to cut up land to redeem a piece of it, and land is not fungible. But it has value – or should – and so I should be able to use it at collateral in the creation of money. I mean, if I could so use it, I could get more things done, creating more jobs in the economy, etc.

The gold standard is just too limiting once the technology exists to use other things as stores of value. And when enough things can be used as stores of value, it become most efficient to create a central bank to issue money, first on the pledge of actual things of value, but then on the credible promise of the creation of unspecified things of value, or even on the promise of tax revenues. And so it becomes possible for governments to generate money that isn't really tied to a reliable store of value.

All this means is that that fiat money is like fire. You can cook with it, and you can smoke in bed and burn your house down. But I'm not here about the gold standard, so its fate will have to wait. I'm here about the Share Standard. I just mentioned the gold standard to provide some conceptual underpinning.

The Share Standard is the principle that every transaction relating to corporate stock should be backed by actual shares of that stock. For example, when I buy or sell a share, I am “betting” that the stock will perform in a certain way relative to other opportunities, but to do so I actually have to change the number of shares of stock owned by people (including myself). I will own more or fewer shares, and the guy on the other side of the trade will own a correspondingly different number. Our trade will be “in” the market and part of the market.

The case for the Share Standard is very simple: the ability to bet on the market without actually participating in the market creates conceptual opportunities for mischief, and the convergence of aggregated money, technology, and deregulation have made the mischief a reality.

The Share Standard does not preclude sophisticated derivative instruments. If I sell someone an option to buy shares I own at a fixed strike price, the option relates to actual shares that I control, and there won't be any more options written than are readily available to satisfy them if they are exercised. Because the option is backed by real shares, it is consistent with the Share Standard. To stay true to the gold standard analogy, however, it is important that I continue to hold the shares. If I sell the shares, the option becomes a "naked" call, and the Share Standard is violated.

Under present law, I can write a call option on shares I don't own. There is no way of knowing whether there will be shares available to meet the promise of such an option. I may have to buy shares to meet my obligation under the option contract, and the need to buy shares when lots of other issuers of naked calls are trying to buy them creates an artificially high demand for shares (in the sense that the demand is not driven by belief in the underlying company's prospects relative to the price of the shares). That sort of buying frenzy cannot happen if all of the options issued are exercisable against people who already own shares. The covered call meets the Share Standard, but the naked call does not.

In the real world, of course, naked calls are rarely exercised. The buyer is “betting” on an increase in the share price, not looking to acquire the shares on the cheap. So, as a practical matter, many “in the money” calls are just sold back the people who wrote them for something like the difference between the current value of the stock and the strike price of the option, and the buying frenzy is averted. But one could imagine a powerful option holder buying up shares in anticipation of the expiration, and then demanding actual delivery. He could sell his own shares to the option writer at an artificially heightened price so that the latter can redeliver them at the strike price. And then sell the option stock into the high market as it settles back down. I don't know whether this sort of thing goes on, but the technology and wealth exist to make it feasible, and the availability of naked calls makes it possible.

The share standard is especially relevant to the short side of the market because of an important assymetry: it is easier to wreck a company than to make it succeed by manipulating its stock price. We'll consider the short side in Part II.

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