
Facebook Derivatives: Wall Street Goes Rogue-er - cwan
http://paul.kedrosky.com/archives/2010/11/facebook_deriva.html
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noname123
Well, derivatives all have to somehow tie back to the underlying. Should be
interesting to see the financial engineering on this.

Depends on the way they'll do this, one way is that they could approach some
major stakeholders of Facebook (e.g., a pool of employees with vested or
unvested employee stock options) and draw up some agreement with that entity
to buy the rights to buy these stock options at a whole-sale strike price
(let's say $0.05/share to buy the share at $75).Then the brokerage firms will
chop these options to different strike price bins and re-distribute to
investors (e.g., $0.15/share for the right to buy the share at $75,
$10.15/share for the right to buy the share at $65; with the broker collecting
a $0.10/share underwriting fees.).

So you are buying an option at a certain strike price to buy a potentially
unvested option to buy a illiquid, pre-IPO stock at a certain strike price. If
this was Google in 1999, someone is going to be rich. But since it is my
opinion that Facebook is going to the way of AOL, I wouldn't buy into it; but
then again, it depends on when Facebook is going to IPO and if it is before
the Web 2.0 exuberance dies down.

~~~
olefoo
If you read the Businessweek article he quotes from, the investors are buying
shares in an entity that does nothing but own shares of facebook. Shares that
they presumably bought on a private secondary market like the one detailed in
<http://www.avc.com/a_vc/2008/08/a-secondary-mar.html> It sounds rather like a
bucket shop to me, and those were made illegal for some fairly good reasons.

~~~
nl
No Bucket Shops are where an entity says trades are going to take place and
then doesn't execute them.

This is just a pretty standard private investment setup, that just happens to
own a single stock.

Even if owning the single stock was a problem - and I don't think it is -
working around it would be trivial. They could invest small amounts in a
number of very low value stocks or in very stable stocks. Both those
strategies would meet any hypothetical "diversification requirement" (which I
don't think exists) without materially changing their exposure to Facebook.

~~~
joshu
Embarrassingly, I always though bucket shops meant something else. (I thought
that this is what you call brokers with heavy flow that could cross much of
their traffic internally without going to the exchange.)

~~~
alex1
> (I thought that this is what you call brokers with heavy flow that could
> cross much of their traffic internally without going to the exchange.)

What you describe here sounds like dark pools[1].

[1] <http://en.wikipedia.org/wiki/Dark_pools_of_liquidity>

~~~
joshu
I think they generally don't go to the exchange, but yeah, pretty similar.

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nl
This seems a pretty unconventional use of the word derivatives.

Unless I'm missing something, the story here is that people are pooling money
to setup a company to invest in Facebook. That's just normal investing -
exactly like investing in a VC fund that invested in Facebook.

I suppose technically they are investing in a Facebook derivative, because
they get returns from the investment company rather than Facebook stock
directly. But people don't say a Vangaurd find is a Walmart derivative just
because it invests in Walmart, nor do they say investing in the Accel Funx X
(which funded Facebook) is investing in a Facebook derivative.

~~~
roel_v
Note that this guy's blog seems to be mostly about ragging on the financial
industry and how it's going to kill us all. Using scary words like
'derivatives' is much more effective for that sort of fear-mongering than
using 'investment fund' which was much less tainted by the economic woes of
the last few years.

~~~
variety
Umm, for one thing, the description of the instruments as "derivatives" is not
due to Kedrosky, but to Avi Levy, the author of the Bloomberg article he was
quoting. You did see that he was quoting another article, didn't you?

Also, it's not a "scare word" in this context at all. It's a fairly neutral
term, and an accurate enough description of what these investment firms are
doing (even if they chose to use other words to market these instruments).

~~~
roel_v
He still was all too happy to adopt the term, and not make any reservations on
its use, wasn't he?

Of course it's _technically_ a neutral term. But in this context, it _is_ a
scare word. When you write a blog that seems to be a pop topic blog for a wide
audience, in today's world 'derivative' _is_ a scare word. The average news
paper reader hadn't heard about 'derivatives' before 2008, and since then he
heard about it every week, usually in the context of how much money they have
cost some firm, how much money they have cost the tax payer, how much money
they have cost pension funds, or how much money they have made for those
greedy bankers in Wall Street, London, Frankfurt or wherever - or a
combination thereof.

So yes, 'derivative' _is_ a term with negative connotations to the wider
public. It is one of the words that are now associated with irresponsible risk
and money out of thin air. It's irrational to blame the use on the instrument,
but hey, it's an irrational world out there.

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billboebel
I am an investor in the Felix fund mentioned in the business week article. All
they did is buy up several million dollars of Facebook stock from original
shareholders, put it into a simple LLC, and then sell shares of that LLC.
Investors pay an upfront transaction fee on the investment, a minimal
operational cost, and then a fee on the backend if there is a liquidation
event but only after the investor gets 100% of their investment back.

This is very similar to how traditional VC funds are structured and the only
reason this is getting press is because it is another story about Facebook.

These funds actually do a service for the original Facebook shareholders
because it allows them to take some cash off the table, rather than waiting
for the IPO.

~~~
abalashov
Given that it is considerably more difficult to change the shareholder
structure of an LLC than an Inc. -- which is the reason institutional
investors don't like startups that are LLCs -- an LLC is a rather strange
choice of structure for this investment vehicle entity.

~~~
billboebel
No idea. But I will ask because now I'm curious.

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d2viant
Investors should steer clear of this, leave this for the speculators who have
money to throw away. You're investing in an instrument that is leveraged
against a company who's financial details are not public knowledge. This is a
very dangerous situation as you're unable to make an objective assessment of
the underlying value.

~~~
cturner
Investing is often dangerous. If you invest in a mining exploration company,
you're investing in minerals which may or may not be in the ground, and a
management which may or may not have the acumen to extract them.

People who think they have edge will invest, and so will some people who don't
have a clue what they're doing. Some people will fit into both categories. I
think that's true of investing generally.

    
    
        you're unable to make an objective assessment of
        the underlying value
    

I'm not contradicting you here, but developing this idea. I'm always
interested to hear the justification that people give for investing in blue-
chip technology stocks like Apple and Google. They rarely deliver a dividend
and some companies have a stated policy of not doing so. What's an objective
assessment for the value of a company that's too big to be acquired, and which
has committed to not delivering a dividend?

~~~
philwelch
After decades of growth, they will grow old and fat and give up and pay
dividends, like Microsoft. And when that day comes, the decades of not paying
dividends will finally pay off in terms of the stratospheric heights the
company has grown to.

Which would be a far more convincing argument if it wasn't the fashionable
thing in the tech industry to try as hard as possible to never grow old and
fat.

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retube
"Unbelievable, dangerous, greed-headed and yet another example of the craven
idiocy of what passes for regulatory oversight in this country."

He provides no justification for this statement. Why is it these things? Given
the title of his blog, I'm assuming he has a pre-disposed bias on such
matters.

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zach
One jump ahead of the lawmen. Impressive.

I would think this is heading for trouble, though. The SEC and public policy
in this area are oriented toward protecting non-accredited investors (let's
call them "noobs") from the potential hazards of stock ownership (getting
"pwned").

Now that being public (and even widely-held) is onerous, setting up a noob-
free server (a private market) seems like a win. The company gets liquidity,
the noobs have no chance of getting pwned, everyone should be happy.

But this particular innovation is a little concerning, because it's primarily
going to appeal to noobs and the total amount of noobs at risk of pwnage can
get much larger than intended. That's when the regulators are going to step
in. So as clever as this seems, this is just begging for trouble.

~~~
nl
This isn't about avoiding non-accredited investor laws, it's about the 499
shareholder limit for non-financial disclosure.

Google ran into the same problem in the run-up to their IPO

~~~
zach
It is primarily about that (q.v. my post on RSUs). But if this reaches an
extreme where hundreds of non-accredited investors (very) indirectly hold
ownership in a private company, it's far more likely to raise regulatory and
legislative eyebrows.

Today, I presume they don't need to hassle with non-accredited investors
because the demand is so huge. But the door would seem to be open to this in
the future since there's not much to stop it, possibly apart from Facebook's
control over transactions.

I admit it's a far-ahead concern. But it's a real danger.

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fleitz
Sounds like an ETF that invests in private companies. I don't see a big deal.

It's not much different than NYSE:GLD.

If people feel that it's a poor investment strategy they don't need to invest
in it. This whole model is probably a phenomenal way to get public money into
a private company and avoid all that regulatory BS that public companies need
to go through. (Note: If you think the regulations are great then just avoid
investing in this kind of company)

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copper
> By creating derivatives of the stock, the investment firms are helping
> Facebook keep its shareholder count at 499 or less, the maximum number a
> company can have before it has to disclose results to the public.

Out of curiosity, what does this imply for stock options? Are people who
exercise them included in this count?

~~~
zach
Yes, they would be. So as a result, there are not a lot of stock options
floating around anymore.

They have been replaced by, you guessed it, derivatives.

~~~
copper
Facebook apparently has 1700+ employees, though: does that mean those who
joined at the 500+ mark were either not granted options, or are not exercising
them? That seems strange to me. Assuming I was given options in a fast-growing
company, I'd want to buy them as and when they vested, to have some protection
against dilution :)

~~~
RockyMcNuts
Facebook got an SEC waiver to go over 500 shareholders -

[http://www.businessweek.com/technology/content/nov2008/tc200...](http://www.businessweek.com/technology/content/nov2008/tc20081120_566312.htm)

The second market in Facebook is definitely pushing the envelope, a role of
the SEC is to make sure people don't get ripped off and are treated fairly.

Clearly promoters shouldn't be able to sell private unvetted securities to the
public without registering and going IPO on a public exchange. But it's also
not clear it's in the public interest to have second markets only the well-
heeled have access to, and that are not subject to public securities
regulation, public price discovery and disclosure through K and Q filings.
Maybe it's also not right to force Facebook to choose between going public
prematurely and issuing shares/options to employees, but at some point for
those shares to be properly valued the stock has to be publicly traded.

When they got the exemption they said it was just to give shares to employees,
not to create a second market. The rules are getting rewritten (or Wall Street
is running rings around them as Kedrosky says).

~~~
zach
Wow! I missed that; I thought there was still a need to do a lot of wrangling.
If they have a blanket exception then that's something else.

I fundamentally like the second market idea a lot because I like private
companies staying private for as long as they want while still giving
employees options for ownership that are at least somewhat liquid. It's really
fascinating to see the mechanisms involve creaking at the joints a little, but
I think the idea is solid.

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jaydub
Investors in private companies need to be accredited per SEC regulations
(correct?) [1]. Do investors in these derivatives also need to be accredited?

Clearly, "because private-company financials are opaque" investing in the
derivatives is speculative. The securitization of Facebook shares is not
inherently "evil", but the issues arise if/when these derivatives are
misunderstood and overly available for public consumption.

[1] <http://www.sec.gov/answers/accred.htm>

~~~
zach
Since they're actually investing in an LLC, the rules (search "506 offering")
would be the same. It can only be "sophisticated" investors and no more than
35 can be non-accredited.

Note that there can be no solicitation or advertising of the offering to the
general public. In practice, as you can see, this means you can leak all the
details to Bloomberg but then cannot comment for the story. Because, you see,
that would be solicitation.

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joelhaus
Most interesting is that for each of these long positions, there's a short.

The key is that these derivatives are synthetic shares of facebook, not true
equity. When available/required, the fund will acquire these shares.

The difference btw this and mortgage CDS, is that this is "equity", not debt.

That's my reading of it anyway. Here's another attempt at an over-simplified
explanation: <http://news.ycombinator.com/item?id=1936037>

~~~
roel_v
As I understand it, there's no long here; there's no other party promising to
pay a certain amount for each share. They just bought options from the people
who had them and in case of an IPO, there will be (hopefully) a cash fountain
that the investors in this company get to tap into. And if the IPO turns out
to be less than whatever they paid for the options, tough luck.

In other words, it seems like all assets are paid for already with the inlay
of the shareholders of the investment vehicle. So I think that disqualifies it
as a long, where no cash changes hands at the time the deal is done, no?

~~~
eru
Depends on how you look at it. The current shareholders of Facebook did not
actually sell the stock. They just sold rights to the stock options. So if you
net out their position, there's no short. If you do not net out their
position, there's a long and an equal short for them, and another long in the
new investment company.

~~~
roel_v
Maybe it comes down to the definition of 'long', I don't know if there is a
well-established one. But since these people who the options were bought from
presumably have contractual valuations of these options, it seems to me that
there is no risk in the deal, except for the valuation at IPO of Facebook
stock. Thinking of it, maybe it's the same as a 'regular' long, i.e. a non-
naked one (I guess there's a real term for it ;) ) I originally had a mental
comparison with naked longs in mind, in which case the risk profiles would
deviate much more from the construction in the article; but yes if you compare
it to a long on an asset someone already has, it may not be that different.

Then again it seems to be that the scary stories and the bad image of shorts
and longs are about the naked variants, and that this is implicit in the
article. That may just come from my lack of grasp on the subject.

------
wladimir
Interesting times. You can see the new IT bubble grow larger every day. And,
just like back then, all kinds of strange 'new' investment schemes form.

------
cantbecool
Is there any good resources to learn about derivatives, options, etc? The
nomenclature of finance is extremely difficult to understand.

~~~
cturner
They're reasonably straightforward concepts in themselves (I originally learnt
shorting from the wiki page), but I struggled to make the jump to get a feel
for them, to be able to build thoughts using them, rather than look on as an
outsider. What Heinlein calls "to grok".

Here's a puzzle in the spirit of building the series of logical gates by
combining NAND gates. You could learn enough about the concepts using
wikipedia. Consider a scenario: the government bans short-selling. Your task:
find a way you could synthesise a short using just forwards.

What are some practical considerations that might make it less practical to do
this than pre-ban shorting?

I find that when I understand how something emerged, I have a good feel for
it. A lot of these concepts go back a long way - stock practices that
developed through trading stock of the dutch east india company. For this
reason, I'd recommend Niall Ferguson, _The Ascent of Money_. Das _Traders,
Guns and Money_ is a good read. I couldn't follow all of it when I read it,
but found it to be good for feel.

There's a late 20th century writer John Kenneth Galbraith who wrote some good
histories. I like _the end of uncertainty_ but it's hard to get. He wrote
others that will be fine.

It would probably be useful to read a book about Drexel Burnham Lambert, and
how Milken developed their junk bond trades. I don't know of one, perhaps
someone else can recommend.

For broader economic picture stuff, I recommend Hazlitt _Economics in One
Lesson_; Schiff _How an Economy Grows and Why It Crashes_; Soros, _The New
Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means_.

~~~
zandorg
The Predator's Ball and Den of Thieves for Milken & Drexel. Avoid Payback
(about Milken) as it goes off on a stupid tangent.

