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Transcript:
The transcript from this week’s, MiB: Campbell Harvey on DeFi, is below.
You can stream and download our full conversation, including the podcast extras on iTunes, Spotify, Stitcher, Google, Bloomberg, and Acast. All of our earlier podcasts on your favorite pod hosts can be found here.
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VOICE-OVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: This week on the podcast I have a special guest. His name is Campbell Harvey, and he is a professor at Duke University School of Business. He’s also the author of a fascinating book — co-author really of a fascinating book called, “DeFi and the Future of Finance.” And if you are at all crypto curious, if you’re wondering why bitcoin is near $60,000, why NFTs have gone crazy, and while lots and lots of banks and financial institutions have been embracing crypto, well, then you’re going to find this conversation absolutely fascinating.
Campbell Harvey is a traditional finance professor, at least that’s how he presents to the outside world studying behavioral finance, the yield curve and recessions, and separating luck and skill and investment decisions. All this stuff sounds pretty run of the mill, middle of the road sort of stuff. But then back in 2014, he was crypto curious and started doing some research, and ended up doing a presentation to one of his classes. And really, it had a massive impact on him because, you know, at the end of the period he expects the whole class to get up and leave. And, you know, spoiler alert, nobody leaves, and half the class rushes the podium to ask him a bunch of questions about this.
And he, you know, really comes to recognize, “Oh, so this is striking a chord with students. There’s something here I need to spend some more time and effort going into it.” That part of — that part of the interview was really fascinating. He tells about what he does with crypto, where he was giving bitcoin away to each of his students so that they had to set-up a Coinbase account and, you know, make a promise to return the coin at the end of the term. And — and what ends up happening is pretty, pretty hilarious and fascinating.
Anyway, if — if you’re remotely interested in anything from the world of DeFi from crypto, NFT, stable coins, God, I could’ve spoken to him for another three hours. I kept this fairly accessible. I had lots and lots of deeper, wonkier questions. But as we were going on through this, it really became clear to me, oh, this is a great primer for people who really want to put a toe in the water of crypto. I found it fascinating, and I think you will also.
So, with no further ado, my conversation with Duke Uiversity’s Fuqua School of Business Professor Campbell Harvey.
VOICE-OVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: My extra special guest this week is Camp Harvey. He is a Professor at Duke University’s Fuqua School of Business. He’s best known for his work on yield curve inversion and recessions, as well as the thorny problem of separating luck from skill in investing. He is a Research Associate at the National Bureau of Economic Research, as well as a Partner and Senior Adviser at Research Affiliates. He is the author of a brand-new book titled, “DeFi and the Future of Finance.”
Campbell Harvey, welcome to Bloomberg.
HARVEY: It’s great to be on the show.
RITHOLTZ: It’s great having you. So, you’re a pretty traditional finance guy, Duke, NBER. How did you get interested in DeFi? When did this start? And — and what prompted it?
HARVEY: I’m not too sure I’m a traditional finance guy. Indeed, five years ago, I announced that half of the empirical research in finance was likely faults. So, I don’t think I’m traditional in any way. But I totally agree that decentralized finance seems far away from inverted yield curves, and luck versus skill, and back testing, and things like that. So, let me — let me tell you the story about how I got involved in this space. And I’ve been involved in this space quite a while.
I was on a — a seven-year teaching hiatus because I was editing the Journal of Finance, and it was a full-time job. When I came back to my asset management course after seven years, I decided to scrap the syllabus and — and basically start over, but certain topics I had to include, like forex. And I wanted to do the — the leading-edge stuff, and I thought, well, there’s this new thing I’ve heard of called “bitcoin.” And this is in 2014.
So, it was below the radar screen definitely, but I’d heard about it. And I just — well, if I’m doing the euro, the pound, the dollar, the yen, why not add a crypto currency? So that’s where I actually started and I began to research this idea. And the more I researched it, the more I realized that this was something really big. And I spent a lot of time.
You know, it was a single — like two-hour lecture in my course, and I spent more time preparing that lecture than the sum of all of the other lectures in my course. And I was nervous because in asset management, I’ve researched this stuff for a long time. I’ve been very fortunate to have relationships with some of the leading-edge firms, so I (inaudible) what goes on in the practice also. I’m very comfortable fielding questions from my students. And, of course, I can’t answer every single question, but I — I’m confident I could find somebody very quickly that could help me with the answer.
But with this crypto stuff, I’m in a position where I’m giving a lecture and it’s possible some of the students know far more than I do. So, I sought some help, and I practiced the lecture, all the stuff, and then I gave this lecture. And again, it was probably the most stressful lecture I’d ever given. And — and, you know, the way it is at — at college where wait at the end of the lecture, everybody gets up and leaves. Wait on the — the minute that it’s supposed to end. Nobody stays late. They just get out of there.
And, you know, I’ve taught for many years, that’s exactly what happens. But after giving this talk on crypto, people were just sitting there. And I thought, “Oh, well, maybe I ended the lecture like way before I should’ve,” but I looked at the clock and we were exactly at time. And people just sitting there, and I said, “Uh-oh, I must’ve really bombed this lecture.” It was a disaster, I guess.
And — and I’m — I’m standing there shell shocked because they worked so hard, and — and for it to fail, ah, it was very disappointing. But then students start to come to the front to talk to me. And — and they said, “We are shell shocked,” like this is a transformational topic. That — and — and a number of them said, “This was the most important lecture of their education.”
RITHOLTZ: Wow.
HARVEY: And that this cannot be just one lecture, it needs to be a broader learning experience, and — and — and so it deserves at least a full course. And that’s where I started. So, I developed the next year into a full course, which was the first blockchain-based course taught a leading school. And then I’ve just continued it. And — and one thing with the space is changing all the time. So, when I was teaching seven years ago, it’s much different than what I teach today.
RITHOLTZ: So, let — let’s go back to that first lecture where — where the students were pretty enthusiastic and — and maybe even dumbfounded. First, did anybody come to the podium and say, “Hey, I own a bunch of bitcoin corn, and I don’t know what to do with it.” And B, were you buying bitcoin all the way back in 2014?
HARVEY: So, no student had a bitcoin, but I actually bought some and bought them to get $300 a coin.
RITHOLTZ: Oh, my goodness, yeah.
HARVEY: And — and this is one of the greatest investment mistakes of my life. I decided — I was on the phone with a reporter from a leading media outlet who was covering crypto also, and I asked him whether he owned any bitcoin. And it’s about just a small amount because I’m worried about conflict of interest. And I was thinking maybe the same thing.
If I’m teaching it, I’ll have a small amount. And indeed, I was giving it out. So, my student …
RITHOLTZ: What — what do you mean giving it out?
HARVEY: (Inaudible) …
RITHOLTZ: Giving it to students?
HARVEY: Yeah, OK, yeah. So, let me tell the story (inaudible).
RITHOLTZ: Wait, so you’re paying them to go to school?
HARVEY: So, what I did was to give $10 worth of bitcoin to everybody. And the deal was the following, they had to set-up an account and, at that time, it was with Coinbase. I would give $10. And then at the end of the course, they would send it back to me and then I would donate it to the university, so that will be my …
RITHOLTZ: OK.
HARVEY: … donation, my annual donation to the university. So, it was basically just to get them set-up with something in their wallet.
RITHOLTZ: Right.
HARVEY: So, I discovered this one complication, and — and that is that once you give a crypto to somebody, there’s no way to enforce giving it back. So many of the students didn’t give back. So …
RITHOLTZ: That’s hilarious.
HARVEY: … and — and …
RITHOLTZ: Because it had appreciated so much?
HARVEY: … (inaudible) here.
RITHOLTZ: Yeah.
HARVEY: You know where I’m going, like sometimes I get an odd email for, “Oh, I remember you gave me whatever it was, like 0.1 of a bitcoin back in 2014, I forgot to give it back. And yeah, here it is.” And it’s, you know, $4,000. So — so …
RITHOLTZ: That’s funny.
HARVEY: … basically what’s happened is a lot of students didn’t get back. And — and we’re trying to remind them to do that because it’s a couple of hundred thousand dollars and — and kind of lost donations to the school.
RITHOLTZ: Wow. So, it’s not …
HARVEY: And …
RITHOLTZ: … that they didn’t give it back because it appreciated so much at the end of the semester, they just like, “Yeah, it’s $10 and who’s — who wants to bother,” and they just got lazy. Is that what I’m hearing?
HARVEY: Yeah, that’s what I think, so many of them just forgot about it. But again, that $10 is massively appreciated.
RITHOLTZ: That’s unbelievable. So, we’re going to talk in more detail about the book, “DeFi in the Future of Finance,” but just give us a broad overview, what’s the basic premise. And — and I get the sense you’re going to talk about how transformational this technology is.
HARVEY: Yeah, it’s kind of interesting to me that the financial system really isn’t that much different today than it was 100 years ago, like the — the exception is digitization, but the basic infrastructure is the same. And I don’t think that it’s specific to finance. We kind of know that technology will transform a number of businesses.
And right now, the way that we interact in finance is with brick and mortar intermediary. So, you’ve got a bank in the middle, you get a broker in the middle. And …
RITHOLTZ: Right.
HARVEY: … that middle layer leads to transactions that are more expensive. So — so think of putting your money in a savings account. That rate is maybe lower than if you didn’t have all of that middle layer, the — the back office and — and all of this stuff. And the same with lending said the rates are — are higher, and there’s a spread that’s effectively taken by the centralized player.
So what decentralized finance is about is essentially returning to where we began in market exchange, and that’s (inaudible) and it’s peer-to-peer.
RITHOLTZ: Peer-to-peer, one-on-one.
HARVEY: And — yeah.
RITHOLTZ: Yeah.
HARVEY: And that’s the key. So, you’re — you’re dealing with your peer directly or a portfolio of peers and through an algorithm, and that’s the key. So, the algorithm basically takes the place of the functioning of a bank or a broker. And when you do this, when you’ve just got an algorithm out there, it makes things much more efficient. So, without that middle layer, it — you’re able to get the sufficiency gain that’s very important for the economy.
So as many different aspects of this, but the key idea is let’s deal with the algorithm directly. And when we do that, it’s going to reduce cost. It’s going to make transactions much more transparent, secure, efficient, all of these things.
RITHOLTZ: So — so let me push back a little bit. And — and by the way, we’ll talk about ACH in a minute, we’ll talk about credit cards in a minute, but let me for a moment take the other side of the argument that nothing’s changed in finance over a century.
Today, I could trade stocks effectively for free. I’m rebuilding a Toyota FJ in South America. I ship cash down using an app. It cost me $3 every time I want to send $3,000 to South America. That used to be impossible. I could get cash out of a machine 24/7. I don’t even have to go to the bank to deposit a check. I take a photo with my phone, and — and that’s a deposit. And if we go to dinner and we want to split the tab, I could Venmo whoever else is at dinner back and forth. It’s like so easy, I think about what technology lets me do today versus I was in college when they first put an ATM in the student union.
It feels to someone like me that the past 20, 30, 40 years has seen an endless array of incremental improvements in the financial system. And then the great financial crisis comes along and everybody seems to lose their minds. Aren’t we overstating it when we say there’s been no improvements in the world of finance?
HARVEY: No, I did make an exception with the digitization, but I think there’s been (inaudible) …
RITHOLTZ: But I mean, isn’t that all the improvements, digitization?
HARVEY: Yeah. Look, you say let me go through your list that you can practically …
RITHOLTZ: OK.
HARVEY: … the trade for free. So …
RITHOLTZ: Right.
HARVEY: … that is — it is true that transaction costs have — have decreased. It is not true to believe that if you trade on Robinhood, you’re trading for free.
RITHOLTZ: Right.
HARVEY: That is just not the case. And then number two …
RITHOLTZ: For sure.
HARVEY: … more importantly, for me to take ownership of a share of stock because the transfer of the ownership, that takes two days. So even in this age of the Internet, in the age of digitization, it takes two days to transfer the ownership of let’s say 100 shares of IBM. That’s just completely unsatisfactory, unrealistic.
And yeah, it’s better in 1920, so it was like five days.
RITHOLTZ: Right.
HARVEY: And then we’ve had change to three days and two days, but that’s just, to me, a totally offside.
So as for the cash apps, yeah, there’s many, many things that have happened to make it a little more efficient to actually do the transactions. But — and I — and I point this out in the book, the current wave of FinTech largely uses the banking infrastructure that exists …
RITHOLTZ: Yes.
HARVEY: … today, the centralized banking infrastructure. And I make the case in the book that, look, the traditional financial institutions, they are being continuously disrupted. And one way about that disruption is the FinTech, so then the yield banks, things like that that make it much more friendly for the user. But given that they are using the same centralized infrastructure, in my opinion, the current wave of FinTech is fleeting. I had a speaker in my course, a very prominent person in the world of DeFi who basically at the end of his talk to my course he said that the current wave of FinTech is like putting lipstick on a pig.
And if you think about it, what he’s saying is, yeah, it’s an improvement, but you’ve got the same constraints of that centralized infrastructure. And what DeFi is doing is not doing an incremental improvement on the current infrastructure, it’s actually building something that’s fresh and new. So, I see, looking forward, that FinTech will definitely disrupt the current financial system, but then eventually the — the centralized FinTech will be disrupted by decentralized algorithms.
RITHOLTZ: So — so let’s talk about what I think is the most expensive part of centralized finance. Personally, I could care less if ACH takes two days to clear stock trade. It doesn’t make any difference to me. I could buy and sell that stock 1,000 times before the first-rate settles, and it doesn’t cost me anything.
But in the book, you use the specific example of credit card transactions and that 100 years ago there was about a three percent cost to send money by wire. And today using credit cards a century later, it’s still a three percent credit card fig. So why does that exist? Why hasn’t it been competed down yet? And what will DeFi do about that three percent VIG, which is the bane of retailers everywhere?
HARVEY: Yeah, it’s — it’s remarkable. I — the example, I used in my book is not 100 years, it’s 150 years. And I show this Western Union wire …
RITHOLTZ: Right.
HARVEY: … transfer from 1873, and it’s for $300. And then there’s another line for the fees, and the fees are $9. That’s like three percent. And — and I tell my students that basically nothing has changed. In this particular example, nothing has changed. It’s a three percent fee.
So, the reason that the fees for credit cards are so high, there’s many reasons, but the leading reasons are the lack of security. So, if somebody steals your credit card, then the credit card company is good for it, right?
RITHOLTZ: Right.
HARVEY: So, you’re not going to lose anything. They cover — and all the charge backs. So that — that’s expensive. The security mechanisms are expensive. And then, of course, just the — the brick and mortar, back office, all the systems, all of that is expensive. So, you put that together, it’s three percent.
We have had again, with FinTech, some — some competition here that’s driven that three percent lower because credit cards offer cashback and all of these other deals. And we’ve had innovations like, let’s say Apple Pay, which is a great deal for the credit card company. So instead of getting three percent, they get 2.5, and Apple gets 0.5 …
RITHOLTZ: Right.
HARVEY: … but it’s massively more secure …
RITHOLTZ: Oh, really?
HARVEY: … when you use it. Oh, yeah, because the pay with Apple Pay, you do the facial recognition. If you’re just swiping a credit card …
RITHOLTZ: Right.
HARVEY: … there’s no PIN, right? That — so in United States, we don’t use the PIN for other credit cards. In Europe, a different story.
RITHOLTZ: Right.
HARVEY: But it’s really much more secure. So, we see the fees being bid down a little bit, but that — that’s the reason. So …
RITHOLTZ: So, let me — let’s say with Apple Pay for …
HARVEY: (Inaudible) …
RITHOLTZ: … a second because it’s such an interesting example. As a user, I have no incentive really to use Apple Pay over a credit card, but it would — it sounds like the credit card companies have a massive incentive to have me use Apple Pay. Why hasn’t there — or a similar biometric security system. Why hasn’t there been a bigger push in that direction by the credit card companies?
HARVEY: So, at the beginning, it wasn’t clear that they really understood.
RITHOLTZ: Right.
HARVEY: So, it seems like, well, instead again three percent, we got to take a haircut, the 2.5. And — and maybe there was an expectation that the regular credit card would have better biometrics or — or at minimum a PIN. But given that we don’t have that, it is way more secure to use something like Apple Pay where you would use a PIN or use the facial recognition. So, it’s much more difficult to — to use like Apple Pay if you’re — if you’ve stolen somebody’s phone …
RITHOLTZ: Right.
HARVEY: … for example. So, the — the security cost that’s attributed to those that use the credit card on Apple Pay is — is way lower. So, we have seen a lot of growth. This is not my area of expertise like credit card …
RITHOLTZ: Right.
HARVEY: … you know, mechanics, and — and the amount of sales that’s Apple Pay or Android versus just a regular swipe, but — but it is much more secure. And — and that’s a major cost. The insecurity is a major issue with — not just credit cards, but banking in general.
RITHOLTZ: We were discussing what makes decentralization so desirable and so valuable, in so many cases, but the counter argument is centralization allows us to put legal protections into place, and security, and anti-money laundering. How do we manage those around decentralization? What — what’s the advantage?
HARVEY: So, it is a tradeoff. And I think that people in decentralized finance understand these tradeoffs. And there’s nothing that’s perfect. There’s always going to be some risk. But decentralization is, again, putting people together, so you deal peer-to-peer without this thick middle layer. And there’s some advantage to doing that.
You’re correct that centralization does have some advantages. So, one advantage is that you can move very quickly whereas a decentralized protocol, the — if there’s a change necessary in that protocol has got to go to a vote of the users or the — the owners of the — the governance. So that could take a longer period of time.
The — the throughput in terms of the number of transactions per second, much greater if you’ve just got one centralized clearinghouse. So there — there are tradeoffs here. But with centralization, these institutions can do what they want.
And we were talking in the previous segment about credit cards. Well, what about like a wire transfer? I did one last week and I had to send some euros to Europe for — you know, for — for some repair bill. And my bank said, “Oh, well, you’re a good customer. We’re going to waive the wire transfer fee.” But then they quoted me the rate and it’s about — that rate is 2.5 percent off the market rate. And he said, “Sorry, that’s the best we can do.”
So — and to send the wire transfer was like swiping a credit card. No different.
RITHOLTZ: Right.
HARVEY: And I think, you know, they’re convincing the customer that — oh, well, this is a favor that we’re doing. No, so they had got control. They’ve got market power, so these large financial institutions, it doesn’t matter who I go to, it’s going to be the same thing where they’re going to quote 2.5 percent off the market rate, and — and I got to pay it. So, it’s very direct and very large cost. So, they’ve got the power to actually do that.
When you go peer-to-peer, it’s nothing like that at all. You’re just interacting with your peers. Somebody is buying, somebody is selling, and — and we’re done. There’s no spread.
RITHOLTZ: Right.
HARVEY: So again, the — the advantage of centralized is that we’re familiar with it. It appears to work. It does work out to some degree with our system, but it imposes these costs. And these costs lead to, in my opinion, opportunities that are not pursued that we really need to pursue.
And if I could give an example of this …
RITHOLTZ: Sure.
HARVEY: … you’re a small entrepreneur. You’ve got a great idea. You think the return on investment is going to be 24 percent a year. And you go to your bank and basically ask for a loan to get this going. And the bank says, “Well, you’re too small. We prefer larger customers, so we prefer one large customer to 100 customers like you, so we’re not going to do the loan even though we like the idea.”
But, oh, here — here’s a credit card and we’ve extended the credit limit on it, and you can just borrow on your credit card, and we know what those rates are. So, the rate …
RITHOLTZ: Exorbitant.
HARVEY: … is 24 percent.
RITHOLTZ: Right, usurious.
HARVEY: So, 24 percent rate. The project is in pursuit. And when the project is in pursuit, you’ve got like a high-growth project that is in pursuit. That’s exactly what our economy needs. We’re stuck …
RITHOLTZ: Right.
HARVEY: … in two percent real GDP growth. And given the size of the obligations that the government is taking on, there’s not many good options. So, you could inflate by increasing the money supply, you could tax and that’s not great for growth, but the best way out is to increase growth. And given the situation that we’re facing today where we’ve got so many people underbanked, so under-banking is the example I gave where you’re not able to get that loan even though you’ve got a good idea, that that is a drag on economic growth.
So, in my opinion, if we take these frictions out or reduce the frictions and allow people to be treated equally, and the judgment is basically on the quality of the idea rather than how much you’ve got, then that opens up the possibility of substantially increased growth in our economy. And we really need that.
RITHOLTZ: So — so let’s stick with unbanked, and it’s funny what you mentioned about doing the wire to Europe. I mentioned the app that I can send money around the world and it cost me nothing, but I’m limited to sending $3,000 that’s the cap. I think it’s every seven days or every five days or — and — and I think that is a nod to the money laundering rules
Let’s talk about how much of the world is unbanked and what DeFi can do to give them access. There was a giant story on 60 Minutes a couple of years ago about some person who set-up a way to move money around by phones in Africa. There’s, you know, a huge swath of people who were unbanked there, and — and that technology has been making improvements. Tell us a little bit about how DeFi can help people who don’t have access to centralize banking.
HARVEY: So, in the world today, there are 1.7 billion people that are unbanked.
RITHOLTZ: Wow.
HARVEY: And there’s probably — we don’t have the exact number on this, probably more are underbanked. And my example that I gave you with the entrepreneur, that entrepreneur had a personal bank account, but they — they were not able to get a loan. That — and that again is underbanking. So, it is a very large proportion. One example I’d like to give — and a lot of the action here is happening outside of the U.S.
So, think of a country like Venezuela that’s in a hyperinflation situation. If you’re really well-off in Venezuela, that hyperinflation really doesn’t impact you that much because you’ve got a U.S. dollar bank account in Miami or somewhere outside of Venezuela. So who is hit the hardest? It’s the — the average person in Venezuela where they don’t have the opportunity to set-up that bank account outside or the amount of money that they’ve got isn’t that large.
So again, the — the world of decentralized finance comes in very conveniently here where if you’ve got a mobile phone, a smartphone then …
RITHOLTZ: Right.
HARVEY: … that serves as your bank. And you can hold token and you might choose to hold token that is backed by U.S. dollars. And effectively, you’ve done the same thing that you’ve protected yourself against a hyperinflation in that country. And effectively, what will happen if that country continues on its course is that people will essentially abandon the native currency. So why do I need it?
I can pay with a U.S. dollar token, and it doesn’t have to be U.S. dollars. It could be anything. It could be a traditional currency like the dollar or the euro, but it could be a token that’s backed by gold. So, there’s many possibilities here. And this is just an example of how to effectively bank the unbanked and the underbanked.
RITHOLTZ: So, let’s talk a little bit about the terminology in the space. So much of it is so confusing, block chains, and forking, and protocols, and NFTs, and DAOs. For someone who’s interested in learning more about this ecosystem, where do they even begin?
HARVEY: So, it is confusing write-down. And this is one of the reasons that I’m doing what I’m doing, so I teach this. I think it’s important for the future, but it’s very confusing. And initially, it was even more confusing because very little material other than some computer scientists writing about various protocols.
Today …
RITHOLTZ: Right.
HARVEY: … there’s a huge amount of information on the Internet about this, but you need to be very careful because some of the information is basically selling a product. You need to go somewhere that’s kind of highly rated.
I — I am working on a four-course sequence for Coursera that takes — takes the — the viewer or the student through four different stages of understanding decentralized finance from the infrastructure, the primitives, and then a deep dive on some of the key protocols, and decentralized finance and go through the mechanics of those. And then the fourth course is about the risks and — and opportunities in the space. So, it is difficult.
And I — I kind of come to the realization that, well, I might have a couple of 100 students at Duke University I want to have a broader impact. So …
RITHOLTZ: Right.
HARVEY: … I’ll be putting this stuff up for everybody to learn from.
RITHOLTZ: Let’s talk, Professor, a little bit about your new book, “DeFi in the Future of Finance.” Give us an overview of the basic premise, what will readers get from this book?
HARVEY: So, the book is written for the millions of people that either works in the field of finance or are interested in that field. And they’ve heard of crypto — maybe they own some crypto, maybe they don’t, but they want to learn more. And indeed, the motivation for actually writing this book is something that I tell my students at the end of my crypto course. And basically, I say to them that I want them to be disruptors, not disruptees.
And this is a highly disruptive technology. It will change finance as we know it. And — and I thought it was important to take that message outside the confines of a single university and put a book together that is accessible to — to anyone. The language is somewhat different than the language of traditional finance, but — but everybody going through the book can figure out the linkages between some of the things that I talk about in — in — in traditional finance and — and see the advantages.
And, of course, it’s also crucial with any new technology for the reader to be fully versed on the risks. This is definitely not a risk-free situation, this is disruptive. There’s going to be many ups and — and downs, but it’s important to go in with your eyes wide open recognizing the sort of risks that you face. But this is basically my way of trying to explain what’s going on.
And when you’re early in on a technology, it is difficult to see what’s really going on. And people in the media often see bitcoin or Dogecoin and — and things like that. It’s all about the price of those two …
RITHOLTZ: Right.
HARVEY: … tokens. And — and decentralized finance has very little to do with bitcoin.
RITHOLTZ: So, let’s focus on decentralized finance. In the book, you talk about the five various flaws of — of traditional centralized finance. What do you think DeFi most successfully attacks in terms of traditional centralized finance?
HARVEY: Well, there are five things that I mentioned in the book, centralized control. So basically, you’re at the mercy of your bank because they are holding your funds and — and there’s various other aspects, whereas decentralized, you are in total control. You own the bank. Effectively, the bank is in your pocket and you can do what you want.
Limited access, we’ve already talked about where this is a technology of financial democracy. It doesn’t matter who you are. You’re treated equally as a peer. There’s no retail customer, broker, banker sort of relationship. Everybody is the same. It might be a banker, but that banker is a peer. It — it might be a retail customer, you’re a peer.
Inefficiency, we’ve talked about also with this 2.5 or three percent all over the place ridiculous, you know, lending rates and credit cards. There’s definite progress that decentralized finance makes.
What we haven’t talked about is lack of interoperability as a problem in our current system where, for me, to transfer some funds to my broker, that could take two or three days from my bank to my broker. So — and that delay doesn’t make any sense in the age of the Internet and gigabit, you know, broadband. So, with decentralized finance, everything is linked together and it’s seamless in terms of — the transfers are — are pretty well immediate.
And number five issue is opacity that you’re dealing with a bank. You don’t really know the health of the bank. You’re relying upon the government, the FDIC to basically insure you, but there’s limits to that insurance. And the FDIC and the regulators have a checkered record of detecting problems in advance whereas in decentralized finance, everything is open.
So, you can see the balances of the people doing transactions. You can see the code that is the algorithm that you’re trading with. You can see the liquidity. It — it — it is completely transparent. So, these five problems, I think, decentralized finance deal with. And probably if you’re asking me to pick one, I would pick the inefficiency that because of the thick layer of middle people in centralized finance, then probably the primary advantage is to get rid of that. And when you’re trading with an algorithm, it’s much more efficient.
RITHOLTZ: That’s really interesting. I’m quite intrigued by the concept of smart contracts. Let’s discuss that a bit. Tell us what’s smart contracts are and how they can be used.
HARVEY: Yeah, so this is one of the main differences between bitcoin and Ethereum. So, bitcoin, you can just transfer funds from one person to another, whereas in Ethereum, there’s another possibility. In Ethereum, you can actually have an algorithm run in the Ethereum blockchain. So, the Ethereum blockchain is more like a computing platform, whereas the bitcoin platform is just purely for transactions.
So Ethereum, you can actually send funds not just to another person which, of course, you can, but you can send them to an algorithm. And that algorithm might actually be what’s known as a — a decentralized exchange or — or DEX, D-E-X. And that allows me to trade, let’s say, one token for another token within that algorithm. So, I send one token to the algorithm and the algorithm sends me another token. It’s a beautiful idea, and it’s — and it’s remarkable that the algorithm testing care who you are, how much you’re actually trading.
And it doesn’t care if you’re a buyer or seller. In — in addition, it is running 24/7. So, this is a very significant idea and — and — and will be definitely disruptive.
RITHOLTZ: I’m kind of intrigued by the concept of smart tickets for live events that — that really moves a lot of the control over who purchases, who prices it, how much gets marked up back to the artist. Can DeFi eventually create a world where if Taylor Swift wants to sell tickets first to her registered fans and allow them to resell it but only up to a fixed price and they get to split the profit between the — the — the fan and the artist, are those sort of things feasible with — with DeFi or are some of these really kind of futuristic pipe dreams?
HARVEY: No. And actually, we talk about ticketing in — in my course, so this is a broader application. So, think of blockchain technology as a technology that will disrupt many areas of business. And that — the low hanging fruit is finance, but we’ve also seen a lot of progress in other dimensions like supply chain and things like that. And the supply chain example is that you’re shopping at your grocery store with that head of lettuce with a QR on it, you scan it, you know where that lettuce was picked, the day it was packed, every — whether the farm is organic, every single hop on the supply chain, and how long it’s been on the shelf at the grocery store. So that’s what blockchain can do.
And ticketing is a great example. It’s very similar. The dynamics are similar that, you know, firms like Ticketmaster and StubHub, they — they take, you know, 25, 30 percent …
RITHOLTZ: Giant.
HARVEY: … of the ticket. Yeah, so it is very little …
RITHOLTZ: Right.
HARVEY: … leftover for the artist. And there is something else that happens that is really important to understand, not just the 25 to 30 percent, it’s that the customer is dealing with Ticketmaster.
RITHOLTZ: Right.
HARVEY: They’re not dealing with the artist, so there is a — a separation, there’s no relationship between the concertgoer and the artist, just like Amazon does with retail. So, you buy something off Amazon, you deal with Amazon, and there’s no way for the — the actual person selling the good to connect with the customer. They only deal with Amazon. So, you break that connection and it’s very, very costly, particularly in the arts.
You can imagine a different system using blockchain technology, and there are companies that actually do this. And the — the company that I like is called True Tickets. And I believe they’re sponsored by IBM right now, but they’re offering a solution where — where you actually do have this direct connection between the artist and — and the — just so basically the artist and the concertgoer.
And you — the synergies are just remarkable that there could be a song that is done outside of an album that’s made available to the people that are connected to the artist. There could be information about the next tour. All of the stuff, there’s a direct connection with the artist, and that’s what we really need.
Of course, you know that in the music industry, it’s notorious for so little goes to the artist.
RITHOLTZ: Yeah.
HARVEY: Really the only thing that’s profitable is — is the concert. And even the concert, the haircut is — is enormous. So, there’s so many layers of middle people and again, you’re — you’re onto exactly the right intuition. You take that — that — that oligopolistic or market power out of this and connect people directly, then everybody is better off. So yes, ticketing is low hanging fruit. We will see some progress on this. But — and this is an important but — the middle people are extremely powerful, enable to fight.
Just like in the financial system, the banks, the exchanges, they’ll try to delay this whether it’s lobbying government for regulation and things like that. I’m convinced that they realize what’s coming. And let me just give you a short story. This happened a little before COVID happened, a major stock exchange, global stock exchange called me in to talk about crypto. It was pretty bag agenda. I show up. It’s their board of directors and their senior management sitting in the room, and they’ve got a single question for me. How long do we have?
So, I think that people have realized they can see the trend. And — and ticketing is — is a very good example of a system that it doesn’t work for the artist. It doesn’t work for the concertgoer, so we need to fix it. And the technology exists to do that.
RITHOLTZ: Let’s talk a little bit about what’s going on in the crypto sector today. NFTs are on fire, bitcoin is approaching 60,000, an investor who wants to speculate with a little money in this area, how should they put that money to work?
HARVEY: So, number one, I think way too much attention is paid to the price of bitcoin. It goes up and down. And indeed, it was interesting when the price crashed in 2018, dropped 85 percent. What was most interesting to me was that the venture capitalists that were investing in DeFi, there was no impact. So even though the cryptos dropped by 85 percent, they were equally as interested.
And what I think are the most interesting technologies are things that are below the radar screen. We hear in the news about bitcoin and Elon Musk tweeting about Dogecoin or — or whatever that there’s a lot of other stuff that is really interesting that’s below the radar in decentralized finance. It is a — a very hot area. So, for an investor, if you’re going to — and I do encourage people to get a wallet and to do some experimentation, but you need to be careful that things like investing in bitcoin, the annualized volatility is about 90 percent. So that’s huge.
So, the stock market is 15 percent. Gold is, let’s say, 15 percent. This is an incredibly volatile asset.
And then some people do margin trading, so if you do 50 percent margin then the volatilities double. So, you need to be really careful, number one, that this is an extremely volatile asset class and you need to be going into this without margin, fully knowing that we could have another situation where you lose 85 percent.
RITHOLTZ: Right. Crypto winter …
HARVEY: Well, number two …
RITHOLTZ: … is what — what a lot of folks call these.
HARVEY: Yeah, exactly, there’s ups and downstream. And number two, you can’t be the so-called “bandwagon investor” where you buy high and — and — and sell low. So, think of those people that were buying at the peak in 2017 at $20,000 and — and then in 2018, the price crashes to $5,000. Think about the people that bought it 20 and sold at $5,000.
RITHOLTZ: Right.
HARVEY: The alternative, you buy at 20 and you take a longer-term perspective. And look where you are today. So — so you need to have a — a longer-term perspective, that’s number two.
Number three, and this is hopefully obvious that you should have a diversified portfolio, and that means you don’t — don’t put all your money into crypto. And even within the crypto, you need to have a diversified portfolio, so more than one not just bitcoin.
And — and then number four is maybe the most important, know what you’re investing. Understand what you’re investing. You buy a share of Apple, you — you might have an iPhone or a Mac or you use iTunes. You understand the business model and you believe that they’re in a good position to build profits in the future.
RITHOLTZ: Right.
HARVEY: You need to do the same thing when you’re investing in crypto. You can’t just take a tip from somebody, “Oh, well, this is what I’ve got.” You need to do your homework and — and figure out what this token is really representing.
RITHOLTZ: Quite interesting. You mentioned earlier that you thought a lot of commercial banks are a bit worried about the risk of DeFi, but we’re starting to see some of these giant financial institutions get involved. I think Visa spends $150,000 on a crypto punk and some other banks have been involved in FinTech and — and some seed companies as they look to basically do an end run around — around centralized banking and disrupt finance. What do you think is going to happen with these big financial institutions? Are they’re going to sit on their hands and become disrupted or are they going to try and muscle their way in and keep a finger in the pie, so to speak?
HARVEY: So, they totally understand this, in my opinion. They note this disruption is coming, and they will do what they can to delay. So, one thing that they can do in the short-term is to become more efficient. So, it’s kind of interesting that we all heard a couple of years ago Jamie Dimon saying that …
RITHOLTZ: Right.
HARVEY: … that anybody caught trading crypto at J.P. Morgan was going to be fired. And — and the reason for that is that they were basically being stupid.
Well, it’s a completely different story today where J.P. Morgan has got a stable coin, which is a type of cryptocurrency. And they fully embraced everything about the space. It’s hard to ignore when the — the spaces are capitalized at $2 trillion …
RITHOLTZ: Right.
HARVEY: … that this isn’t a novelty anymore. So, these banks will do a number of things. So, they will use the space to their advantage and — and the stable coins are — basically hark back to the — the era of — of free banking where banks for quite a while in the U.S. were able to issue their own currency backed by various things. So that’s essentially what the banks will do.
It — they — they tried to do other things. You mentioned crypto punk, but Visa actually tried to acquire Plaid for $5.3 billion. And the reason that they wanted Plaid was this lack of interoperability. That was one of the great disadvantages of centralized finance that is really hard to move money from your broker to your bank or vice versa, but that was blocked by the regulators. So — so they completely get this that both the combination of FinTech and decentralized finance, this is an existential threat to their business. So, they will try to do things, they’ll make some investments, they’ll work on the politicians, will try to do the maximum sort of regulatory push. All of this are — are tools that they will use fully realizing that it’s just a matter of time.
RITHOLTZ: That’s interesting. We haven’t talked about the largest company in crypto is probably Coinbase. They’re publicly-traded, but it’s kind of ironic they’re also a centralized company. Tell us a bit about Coinbase’s role in the ecosystem.
HARVEY: So Coinbase, very important in terms of the credibility of crypto. And Coinbase made it a lot easier for people to get into the space. So instead of actually having to worry about your private keys and securing them, you could use Coinbase, a third party, to take care of that just like we use a broker. So, we don’t worry about the actual physical ownership of 100 shares to IBM, the broker handles that for us.
So Coinbase was very important in getting people and they’re fully regulated. There’s more than 10,000 exchanges in the world and probably more than 95 percent of them are very questionable, especially in terms of the volume that they report and the sort of deal that you get when you’re buying or — or selling big spreads. So Coinbase is also insured, which is interesting, and it is centralized.
So, the way that I described Coinbase is — I call it CeDeFi, so C-E-D-E-F-I. So, it’s centralized …
RITHOLTZ: Centralized DeFi.
HARVEY: … decentralized finance. So, they deal in a lot of decentralized financial protocols, and tokens, and stuff like that, but they are centralized. And Coinbase and Binance, their main competition is what’s known as decentralized exchange or DEX.
RITHOLTZ: Right.
HARVEY: So, if you look at the amount of trading that’s actually happening, there’s huge growth in this DEX trading. And the DEX is where you’re trading with the algorithm, so there’s no middle person like Coinbase. The disadvantage of the DEX is maybe many will consider as an advantage is that you hold your — your — your private keys. There’s no third party that’s — that’s actually in the middle.
RITHOLTZ: So — so let’s stay with that a second because there have been all sorts of crazy stories about lost passwords, hundreds of millions of individual dollars lost by some people, and — and I’ve seen estimates of 20 to 30 percent of all coins have been lost due to either lost passwords or damaged hard drives. When you go through Coinbase, they take the liability of that off of you. In other words, you don’t have to worry about a damaged drive or — or lost password, they’ll make sure you have access. And I’m assuming it’s a very secure way to access as secure as a regular bank.
HARVEY: Exactly, so they deal with the custody. And this has also been a big deal for investment funds, so …
RITHOLTZ: Right.
HARVEY: … they’ve seen the crypto complex grow dramatically to $2 trillion, and they’ve been struggling with the custody issue. So …
RITHOLTZ: Right.
HARVEY: … like how — how do we secure these private keys. So, the solution is to have a custodian, and that’s another thing that Coinbase actually does very successfully is they both serve as a custodian for like a hedge fund or a mutual fund if they’re interested investing in — in crypto. So Coinbase, again very important in terms of the evolution, but I do see the trend, and the trend is towards trading directly between peers. And then you do need to worry about custody.
Custody is a risk that they go through in a lot of detail. You refer to kind of losing a password and there’s this story in The New York Times where this programmer had crypto in a hardware wallet, so that means …
RITHOLTZ: Right.
HARVEY: … that the private keys were in the wallet, but then he forgot the password. And the way that this hardware wallet actually operates is that you get 10 tries, and if you’ve fail on the tenth try, then the — the hardware is physically destroyed so you can never recover …
RITHOLTZ: Right.
HARVEY: … what’s in there. So — and so you — you basically just try it eight times, got two more, and over $200 million of — of bitcoin is trapped there.
So, there are other technologies today, so you can have just a regular custodian. You can have a shared key, so you split the key in the three pieces. You’ve got maybe one on your smartphone, one on your desktop, and then there’s a custodian that’s got the other third. And you need two or the three to reconstitute. So, if you lose your mobile phone, your computer crashes, no big deal, you just put it together.
In this technology, we’ll be seamless in the future. So right now, it’s a little clunky and that’s because we’re just so early in this technology, so we’re less than …
RITHOLTZ: Right.
HARVEY: … one percent in, and there will be issues …
RITHOLTZ: Wow.
HARVEY: … like this.
RITHOLTZ: That’s pretty amazing. There was another story in — I think it was the BBC. Somebody threw out a drive when they were cleaning their house, didn’t realize that it had their crypto password on it, but the — the bigger issue, the longer-term issue is, “Hey, you know, these are really secure cryptography access keys today, but we’re not that far away from really quantum computing being more viable.” What happens in the future when we see a massive order of magnitude improvement in computing power? What does that do to these supposedly secure access keys? And I guess it’s as true for J.P. Morgan and Wells Fargo as it is for bitcoin and Ethereum.
HARVEY: Sure. So, let me answer this. There’s many different dimensions to your question. So, the first thing is that quantum computing isn’t really a threat to the current security in bitcoin or Ethereum, so the way that blocks are added is pretty well immune. And both bitcoin and Ethereum use something that’s called “proof of work,” which is environmentally quite reckless. But Ethereum …
RITHOLTZ: Right.
HARVEY: … has got a — a strategy to (inaudible) to a different system that will be much more energy-efficient. It’d be very energy-friendly, frankly. So — so that’s the — the first thing.
The — the second thing is that it is true that …
RITHOLTZ: Right.
HARVEY: … that with quantum computing in the future it might be possible to basically reverse-engineer the private key. So, given that you got a public address that is possible theoretically to go the other way. And you might think, “Oh, well, that’s a disaster,” but it isn’t. It’s not really a big deal because already we’ve got quantum proof capabilities, and it’s really simple when we get close. All you need to do is to send your crypto to another address that you own and just sign it with a quantum proof signature.
So, I’m not worried about that at all. It is kind of interesting that some of those lost bitcoin might be able to be recovered with this.
RITHOLTZ: Really, really intriguing. And I know I only have you for a limited amount of time and I have to get to some of your previous work before we get to our favorite five questions, and I have to lean into. Let’s talk a little bit about yield curve inversion. What does that tell us about the likelihood of a future recession?
HARVEY: Well, actually it was interesting the last time I was doing a podcast, but Bloomberg was 2019, at the beginning of July, the yield curve had inverted, and I made a recession call for 2020. Little did I know that COVID would strike and — and cause such an unusual recession. But this is my dissertation work at the University of Chicago that I showed that yield inversions precede recessions.
At the time when I’m defending my dissertation, the record was four out of four with no false signals that …
RITHOLTZ: Right.
HARVEY: … yeah, I could’ve been lucky. My committee was kind of skeptical, but the theory behind the measure was sound I passed. And usually, what happens after you publish an idea is that if you’re lucky, it becomes a weaker effect to other sample. And if you’re not very lucky, it completely goes away.
But for my particular situation, the yield curve inversions predicted accurately the next four recessions, including the global financial crisis recession where it gave …
RITHOLTZ: Right.
HARVEY: … advance warning of a year. So — so it’s eight for eight. Right now, I haven’t really done research in this area in quite a while, but it — it’s held up. And it’s — it was something completely unexpected that I’d still be getting questions about my dissertation so many years after I published it.
RITHOLTZ: Let’s talk about another area of research that you’ve — you’ve worked in. Some people have had outstanding investment results and they’re lucky, and other people have had an outstanding investment results because they’re skillful. How can we tell the difference when all we see is effectively, hey, that turns out to be a great investment?
HARVEY: Yeah, so this is my recent research stream is focused on luck versus skill. And it’s really hard to explain, but I think people really want to believe in that upside. They look at the back test and yeah, yeah, this looks really good, and — and I think that this is going to repeat. And it often doesn’t because the back tests are — are overfit.
So, in my recent research stream I proposed a number of different ideas to kind of adjust back test and — and a protocol to really understand the past performance. It comes down to the culture at the asset management firm. Do they just want to gather money in the short-term and …
RITHOLTZ: Right.
HARVEY: … collect the fee?
It — it also comes down to investors asking the right question. So — so, for example, a presentation is being given on a new product and here’s the back test. And — and what I do sometimes very strategic question. I’d — I say, “Oh, that’s really super interesting, very impressive work. Oh, did — did you try variable X?” And then the response might be, “Oh, yeah, we tried that, but it didn’t work.”
So as soon as I hear that answer, I know that there’s been extensive data mining.
RITHOLTZ: Right.
HARVEY: And it is like — it’s like seeing a cockroach in your house. You know when there’s — you see one that there’s a dozen behind the wall. And — and that sort of small indication is that this product in the back test has been overfit. When it goes live trading, you’re going to be disappointed. So — so what do you actually want is in the back test not to choose the best one. The best one is the one that’s most likely to disappoint in — in live trading, so you need to do this in a way that minimizes the overfitting in a back test. And what we — what we want is to invest in a product that will repeat its past performance. We don’t want to invest in a product that, you know, the advertised Sharpe ratio is two and — and we get 0.2 in live trading.
RITHOLTZ: So — so is this why you’ve said half of all the financial research out there is likely false, a combination of overfitting, and selection bias, and all the other fun reasons why back tests are — can be somewhat misleading?
HARVEY: Yeah. And I said the half of the empirical research and finance that is published in academic journals, the key is to understand the incentives. So, the journal editors compete in terms of what’s known as an impact factor, the number of times that their articles and their journals are — are cited by other journals. And they know that if they publish a result that is a non-result, so you try a trading strategy, for example, and it doesn’t work, if they publish that nobody is going to cite it. So — so the authors know that they need to — to deliver something that’s really interesting, and it’s what we call a positive result. So, this trading strategy delivers a a– a very high Sharpe ratio. So, they know that.
And the data mining because these academics, they need to publish in the top journals to get promoted, so — so the data mining begins and then you get a select sort of a paper flow that’s going in with the data mined results. And — and — and you put this together and you combine that with a mistake that — that many people have made in kind of the execution of the statistics. It might be that you try 100 things and there’s one that works, and — and then you even admit that you tried 100 things, 100 different versions of the trading strategy, but this one works really well.
Well, you expect that out of 100, five would work just by random chance. So, if you’re presenting one, it’s probably not significant. It will not hold up in live trading.
So, the incentives to find that really interesting result that you know will be cited and the journal editor will like it, and you combine that with a mistake of not adjusting for all of the possible things that you tried …
RITHOLTZ: Right.
HARVEY: … then you get to this 50 percent number. It is also important to realize that, in my opinion, the problem is — is less severe in the practice of management because in the practice management, if you really overfit and if you get people to invest, and if your arrangements are not just a fixed fee, but an incentive fee or performance fee, then if the product does perform, you’re not going to get any performance fee and you’re going to lose a reputation.
RITHOLTZ: Right.
HARVEY: So, in the practice of finance, there’s no equivalent to academic tenure. So, if you don’t perform, you’re out. So, I think the incentives are better aligned in the practice of asset management and that sort of research much of which we don’t see, so you don’t publish the …
RITHOLTZ: Right.
HARVEY: … the mechanics of a really good trading strategy.
RITHOLTZ: Yeah, Renaissance Technologies hasn’t released any white papers as to how they’re doing 40 percent net of fees year after year. And — and I want to add this sort of research issue is not just in academic finance, but it seems to be across, you know, many, many fields. Reproducibility of — of results are very, very challenging, so it’s more than just form-fitting, it’s even the basic concept of research seems to be somewhat problematic and in both academia and in the real world.
HARVEY: So, you’re correct that other fields have actually come to this realization well before the field of finance. Medicine, for example, they fully realized that half of their research findings are false. And you could argue that that’s way more important than finance. So, in finance, we’re talking about like some alpha, and …
RITHOLTZ: Right.
HARVEY: … in medicine, we’re talking about life or death. So again, we need to have a proper perspective on this.
RITHOLTZ: I know I only have you for a little while longer, so let’s jump to our favorite questions that we ask all of our guests starting with what have you been doing to stay entertained during the pandemic. Tell us what you’re streaming, either Netflix or Amazon or anything you’re listening to and enjoying.
HARVEY: I’ll tell you what I’m streaming on Netflix is a Finnish drama show called Bordertown, highly recommended, very interesting. It’s — it’s dubbed, but it’s — it’s well done. But in terms of podcasts and things like that, really what I’m — I’m doing — I’m focusing on one particular podcast, which is not for entertainment necessarily, but more on the DeFi space and it’s called Finematics. That’s F-I-N-E-matics. And it’s really nicely done where the presentations are like 17 to 20 minutes long, animated, but really trying to understand some of these complicated concepts in — in the crypto space.
RITHOLTZ: Really interesting. Tell us about some of your early mentors. Who — who helped to shape your career?
HARVEY: Well, I’ve just been so lucky that at just — my timing, I think, I didn’t realize that, at the time, it was just so good and — and again just purely good luck that I’ve had the opportunity to interact with the greats of finance. So, my chair is Eugene Fama. My committee, Merton Miller and Lars Hansen.
RITHOLTZ: Yeah.
HARVEY: But I also had and have the opportunity to interact with Bill Sharpe, Myron Scholes, Dick Roll, Steve Ross, Bob Merton, and — and even Fisher Black.
And let me just briefly tell you my introduction to Fisher Black. I was an assistant professor — junior professor, and I was working late at the office. Well, actually, it wasn’t late for me. It was both 9 P.M., and I get a phone call. And Duke had one of the early call ID, and I could see the calls coming from Goldman Sachs. And I think it’s a buddy of mine from Chicago that’s working late just like me. I pick up the phone just assuming it’s him and — and make some disparaging remarks. And then there’s a long silence. And the person says, “Is this Campbell Harvey?” And I realized, uh-oh, somebody else. And then he said, “It’s Fisher Black.”
And for a junior person to get a call from Black, who everybody knows is going to win the Nobel Prize …
RITHOLTZ: Right.
HARVEY: … it was shocking. So — so he said, “I’m reading your paper here, and in your Table 2, I don’t believe.” I said, “Well, what do you mean you don’t believe?” So, well, you’ve engaged in data mining to get this particular result. And these results are not credible.
And I said, “No, there’s not data mining.” This is — all I did is exactly what I said. There was no going variable by variable. It was a predictive regression for the S&P 500 that I just basically — this is what people have done, and then I just — I just presented that. And he said, “No, it’s — it’s not credible, not credible.”
And so, it was interesting we had this conversation and many other conversations, and — and we developed a good relationship. And — and (inaudible) …
RITHOLTZ: How did you convince him it was a legitimate research paper?
HARVEY: So, I — I couldn’t. So, he’s just totally convinced. So many years later, I decided to basically do the out-of-sample test. And so, I replicated my original result, and — and I found using that I collected the data again, and I found I got it almost exactly the result in that Table 2.
But then I did the other sample, 25 years (inaudible) a sample. And the other sample, there was zero predictability.
RITHOLTZ: Really?
HARVEY: So, Fisher Black was right. And …
RITHOLTZ: No kidding.
HARVEY: … it is a lesson that I’ve learned. And the lesson is I didn’t do any data mining, so it was clear that I was telling the truth. I didn’t do any data mining.
RITHOLTZ: Even a legit paper can have structural problems in it.
HARVEY: But what I did was I relied upon the results of other academics. So — so basically, they might have been doing the data mining, and then I just took their paper and then implemented it, and — and — and basically, it’s — it’s essential delegation.
RITHOLTZ: Right, garbage in, garbage out, right?
HARVEY: Yeah. So, this is — so he was — he was correct. And — and I — obviously, that experience was really important for me in shaping my research agenda. My presidential address to the American Finance Association is exactly on this topic. So, he was extremely influential in terms of my development and the idea generation.
RITHOLTZ: Meanwhile, that’s some murderous row of mentors you had over your career. It’s really quite an amazing list.
Let’s jump to everybody’s favorite question. Tell us about some of your favorite books, what are you reading now, and — and what are some of your favorite books to recommend to students.
HARVEY: Well, that probably won’t be that interesting. I — I began thinking I was going to be an English major, so — so I do read. And my tastes are maybe little unusual. So, I’m a James Joyce not in terms of reading everything that he’s done, which is incredibly challenging to do, but very rewarding for me. In terms of what I’m reading right now, I’m reading Danny Kahneman’s book on noise. I do work in behavioral finance also, and I’ve been struggling with some of the issues that are prominent in his book in terms of some of my recent research so that — that’s something that interests me a lot.
And then I’m doing something really geeky that I’m trying to make my way through the third edition of the “Golden Bough.” And maybe some of your readers might — or listeners will — will pick up and — and take a look at what that is. It’s all online, it’s very long, but it’s the sort of thing that interest me. And it’s essentially how people come to believe in something. So, expectations are something that I’ve thought about for a very long time. It’s very important for my research. One of my research streams tries to measure those expectations, but this is a much deeper analysis of how beliefs are actually formed, mythology and — and things like that.
RITHOLTZ: More than anticipating the pleasure of an event or purchase, you’re talking about how we start to conceptualize entire frameworks or mythologies.
HARVEY: Exactly, so very important just the way that it’s presented. And — and some things happen that might be random, but others are not.
RITHOLTZ: So, before I go to the next question, I have to ask how does the world of stock memes fit into this. That this seems to be that sort of investment narrative seems to be dominant over the past five years. Do you — do you look at those? What do you think of those?
HARVEY: Sure. So, this is extremely interesting to me because we’ve been on a trend where the retail investor has become a smaller and smaller part of the total amount of investing for many years. However, with the rise of certain FinTech, it’s been a lot easier for the retail investor to actually get into the market with apps like Robinhood, for example. So, we’ve seen a big turnaround, so the proportion of the retail investor — the total market maybe was 10, it’s up to 15. Maybe it’ll be 20 over the next year.
And — and what happens there is that the retail investor doesn’t have access to the sort of information that an institutional investor has got access to. You know …
RITHOLTZ: Right.
HARVEY: … the data, the computing capability, they’re not working on this full-time, but they’ve got the crowd. So, you might have a dedicated team in a hedge fund working on a problem, but the retail investor — even though part-time — there might be, you know, 100,000 people that are contributing. So effectively, what we’re — we’re seeing is the possibility of kind of a decentralized hedge fund, if you think about it that way.
RITHOLTZ: Like Reddit, Wall Street, that’s …
HARVEY: So, I think it’s very interesting like how the space evolves. It is — it has some downsides where a bandwagon has jumped on, and it basically drives a stock well beyond its fundamentals. But usually, you would have shorting going on and to bring the stock back down to its fundamental level, but some of these hedge funds, the risk of shorting has gone up dramatically. It’s seen what’s happened. So, when people step out of the shorting, that means that you’ve this asymmetry, and it’s just more likely that you’ve got a misevaluation.
So, in my opinion, given what’s happened, I think that the market will become less efficient in the short-term, and that provides some opportunities, of course. But eventually, I think that the information gathering will become cheaper, more efficient, will kind of return to where we were. But in the short-term, we get situations like GameStop and EMC.
RITHOLTZ: Quite fascinating. We’re down to our favorite last two questions. What sort of advice would you give to a recent college grad who is interested in a career in either investment management or finance or crypto and DeFi?
HARVEY: So, the key thing to realize — and I give this advice to my students. The key thing to realize, in my opinion, is that finance will not look like it has in the past in the future. So …
RITHOLTZ: Right.
HARVEY: … we are in the midst of a structural change. So, it’s really important to have a vision of the future. And just a naïve extrapolation from the past is not good enough. So, I — many of my students take the job at the traditional bank or investment bank. And my advice to them is after graduating, that doesn’t mean that you’re finished your learning. You need to know what you don’t know.
And my course and my book is maybe a good example. After you read that book, you will know what you don’t know, and you will know that there’s enough — a lot more learning that has to happen.
So those students that go into the traditional sector, I say, “That’s fine. You’re going to learn something. You need to continue the quest of knowledge in this difficult space. And the first day that you arrive, you need to be thinking about the next stop. And, hopefully, that stop is somewhere in the deep high (ph) space. Pay down your student loan and then take some risk. Go to a venture. You’re going to learn a lot.
The venture will probably fail, but it doesn’t matter. You’re going to learn a lot and you’ll be able to go to another venture very quickly. So, it’s not as risky as you think. But again, it’s way better to be at the vanguard of disruption rather than at an institution that is doing everything possible to hang on to extend that runway fully knowing that they will be eventually replaced by algorithms.
RITHOLTZ: Really interesting. And our final question what do you know about the world of finance today that you wish you knew 30 years ago or so when you were first starting out?
HARVEY: So, I guess, what I didn’t fully appreciate — and it’s kind of embarrassing because when you do economics at the University of Chicago, it’s — it’s all about economic incentives and — and how that shapes behavior. And we’ve talked about this a little bit that I’ve really realized that the — the research in my field is — is shaped by economic incentives.
So, at most schools in the world, well, maybe 90 percent or more schools, just a single publication in a very top journal is a job for life. You’ve done it …
RITHOLTZ: Right.
HARVEY: … right? So, Journal of Finance publishes 70 — 7-0 articles a year, so it’s very difficult to get in to a journal like that.
So, to get promoted, you’ve got to hit this top journal, and that causes data mining. And …
RITHOLTZ: Right.
HARVEY: … and some of it might even be unconscious where you’re — you’re trying to — to look at various different techniques of estimation, and you just happened to pick the one that works the best. So, these incentives are really, you think of, influenced research and has led to a problem with our research. And that when you take that research into live trading, it doesn’t do as well as what was published. And I think it’s purely the result of these incentives.
I was naive graduating and thought that, well, this is just about the pursuit of truth. Well, that’s part of it, but for many people, it’s about the pursuit of a job for life.
RITHOLTZ: That’s quite, quite fascinating. Professor Camp Harvey, thank you for being so generous with your time. You can pick up his new book, “DeFi in the Future of Finance” wherever you get your usual book purchases.
If you enjoy this conversation, well, be sure and check out any of our previous 376 podcasts we’ve done over the past seven years. You can find that at iTunes, Spotify, wherever finer podcasts are sold.
We love your comments, feedback and suggestions. Write to us at mibpodcast@bloomberg.net. Sign up for my daily reads at ritholtz.com. Check out my weekly column at bloomberg.com/opinion. Follow me on Twitter @ritholtz.
I would be remiss if I did not thank the crack staff who helps put these conversations together each week. Nick Falco is my Audio Engineer. Michael Batnick is my Head of Research. Paris Wald is my Producer/Booker. Atika Valbrun is our Project Manager.
I’m Barry Ritholtz. You’ve been listening to Masters in Business on Bloomberg Radio.
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