[Cryptography] North Korea and Sony

[Jerry Leichter]

On Dec 10, 2014, at 7:15 PM, John Levine <johnl at iecc.com> wrote:
>> You'd think that the values are ultimately grounded in the loans backed by land or
>> machines in a factory, ...
> That hasn't been true for over a century.  Loans are at least as
> likely to be backed by a company's cashflow, or IP assets.  (Would you
> rather have a slice of Google's cashflow or Taylor Swift's song
> catalong or Detroit's land?)
Well, sure, but the point is that the naive view is that ultimately everything is backed by something with some kind of inherent value.  Taylor Swift's song catalog is valuable because enough people like to listen to her music; Google *has* a cash flow because it delivers ads - which have value exactly when they get people to pay for things.

This view is "naive" because no one's really been able to come up with a way to define "inherent value" except in relation to other things of "inherent value" - it's the market that makes the value.  But we are all ready to believe that edible food, say, pretty much always has some kind of inherent value, even if we can't quantify it.

None of this matters to the point I was making though:  The financial system abstracts money so far from the underlying "things of value" that we might think underpin it that any underpinning becomes irrelevant.

> Nonetheless, you are quite right that the financial system is
> interconnected in ways that are often not apparent until it becomes
> apparent in very exciting ways.  It was a big surprise when people
> realized how much of the world's complicated financial assets included
> insurance from AIG, and how widespread the damage would be if AIG
> defaulted.
This was one of the big lessons of the 2008 disaster.

> There have been efforts to decouple, notably increasing the amount of
> capital that banks have to hold, which increases how much damage they
> can absorb before passing it along, but of course they've strenuously
> resisted that, becuase higher risk means higher returns in the short run
> which means higher management bonuses.
It's not just management bonuses - it's also return to investors.  All the incentives in the system point in the direction of higher leverage and higher risks.  That's why the grand vision of "deregulate and let the market do its magic" is a bunch of crap when it comes to financial firms.  The market will indeed do its magic - but where it ends up taking the economy is not necessarily a place the vast bulk of people dependent on the economy would want it to go.

But to return to the point:  Increased capital is the classic solution to the classic risks that financial firms face.  What Sony reveals is an entirely new class of risks, which the classic techniques cannot mitigate.  The point of capital is that the firm can use it to pay debts without any limitations:  It's highly liquid, it never has to be paid back.  But a nominally liquid asset may be inaccessible if all your computers are trashed.

I suspect the next step will be something akin to an escrow account for capital.  Having a firm hold its own capital, in a world where the mechanisms it uses are subject to severe attack, isn't sufficient protection.  Somehow, the capital will have to be placed outside the day to day control of the institution it protects.  Figuring out how to accomplish this - while ensuring it can be released quickly when needed - will be a big, complex jobs.

                                                        -- Jerry