May 26, 2014

Why triple-entry is interesting: when accounting is the weapon of choice

Bill Black gave an interview last year on how the financial system has moved from robustness to criminogenia:

If you can steal with impunity, as soon as you devastate regulation, you devastate the ability to prosecute. And as soon as that happens, in our jargon, in criminology, you make it a criminogenic environment. It just means an environment where the incentives are so perverse that they are going to produce widespread crime. In this context, it is going to be widespread accounting control fraud. And we see how few ethical restraints remain in the most elite banks.

You are looking at an underlying economic dynamic where fraud is a sure thing that will make people fabulously wealthy and where you select by your hiring, by your promotion, and by your firing for the ethically worst people at these firms that are committing the frauds.

No prizes for guessing he's talking about the financial system and the failure of the regulators to jail anyone, nor find any bank culpable, nor find any accounting firm that found any bank in trouble before it collapsed into the mercy of the public purse.

But where is the action? Where is the actual fraud taking place? This is the question that defies analysis and therefore allows the fraudsters to lay a merry trail of pointed fingers that curves around and joins itself. Here's the answer.

So in the financial sphere, we are mostly talking about accounting as the weapon of choice. And that is, where you overvalue assets, sometimes you undervalue liabilities. You create vast amounts of fictional income by making really bad loans if you are a lender. This makes you rich through modern executive compensation, and then it causes tremendous losses to the lender.

The first defence against this process is transparency. Which implies the robust availability of clear accounting records -- what really happened? Which is where triple-entry becomes much more interesting, and much more relevant.

In the old days, accounting was the domain of intra-firm transactions. Double entry enabled the growth of the business empire because internal errors could be eliminated by means of the double-links between separate books; clearly, money had to be either in one place or another, it couldn't slip between the cracks any more, so we didn't need to worry so much about external agents deliberately dropping a few entries.

Beyond the firm, it was caveat emptor. Which the world muddled along with for around 700 years until the development of electronic transactions. At this point of evolution from paper to electronic, we lost the transparency of the black & white, and we also lost the brake of inefficiency in transactions between firms. That which was on paper was evidence and accountable to an entire culture called accountants; that which was electronic was opaque except to a new generation of digital adepts.

Say hello to Nick Leeson, say good bye to Barings Bank. The fraud that was possible now exploded beyond imagination.

Triple-entry addresses this issue by adding cryptography to the accounting entry. In effect it locks the transaction into a single electronic record that is shared with three parties: the sender, the receiver and a third party to hold & adjudicate. Crypto makes it easy for them to hold the same entry, the third parties makes it easy to force the two interested agents not to play games.

You can see this concept with Bitcoin, which I suggest is a triple-entry system, albeit not one I envisaged. The transaction is held by the sender and the recipient of the currency, and the distributed blockchain plays the part of the third party.

Why is this governance arrangement a step forward? Look at say money laundering. Consider how you would launder funds through bitcoin, a fear claimed by the various government agencies. Simple, send your ill-gotten gains to some exchanger, push the resultant bitcoin around a bit, then cash out at another exchanger.

Simple, except every record is now locked into the blockchain -- the third party. Because it is cryptographic, it is now a record that an investigator can trace through and follow. You cannot hide, you cannot dive into the software system and fudge the numbers, you cannot change the records.

Triple-entry systems such as Bitcoin are so laughably transparent that only the stupidest money launderer would go there, and would therefore eliminate himself before long. It is fair to say that triple-entry is practically immunised against ML, and the question is not what to do about it in say Bitcoin, but why aren't the other systems adopting that technique?

And as for money laundering, so goes every other transaction. Transparency using triple-entry concepts has now addressed the chaos of inter-company financial relationships and restored it to a sensible accountable and governable framework. That which double-entry did for intra-company, triple-entry does for the financial system.

Of course, triple-entry does not solve everything. It's just a brick, we still need mortar of systems, the statics of dispute resolution, plans, bricklayers and all the other components. It doesn't solve the ethics failure in the financial system, it doesn't bring the fraudsters to jail.

And, it will take a long time before this idea of cryptographically sealed receipts seeps its way slowly into society. Once it gets hold, it is probably unstoppable because companies that show accounts solidified by triple-entry will eventually be rewarded by cheaper cost of capital. But that might take a decade or three.

H/t to zerohedge for this article of last year.

Posted by iang at May 26, 2014 10:25 AM | TrackBack
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