I was advised by A, the software coding capitalist socialist to pen my last conversation with him into a blog post failing which he promised to give me a kick in various sensitive parts of my rather large economy size posterior. This is of course, a fate best avoided, so I will get cracking!
The post describes one of the ways I think about economic markets. It should not be taken too literally, and a careful and pedantic reader will find several holes in the story that I am going to tell, but this will serve as a very basic guide to the way our market based system has evolved.
The Beginning — The barter system
The barter system was the original way men could trade. one item of value was traded for another item (or service) for equivalent value.
However, it faced a whole bunch of problems, largely because barter depended on the co-incidental needs of two counterparts who just happened to need what the other person had. Such co-incidence may make for good stories, but very rarely does it make a good marketplace.
Thus was born money, which became a proxy for value
The first derivative — money
There is the standard definition of money. If you want that you can read an economics or commerce textbook. For this post though, lets think of money as a proxy for value. Money’s own value is only in the fact that other people exchange it for items of value. So we can think of money as a first derivative of value.
Any derivative of a product imposes costs. So trading with money imposed costs like keeping track of money, worrying about money losing its value, people stealing your money, or a hundred other things. But the benefits of money far outweighed the small costs of adopting it, and thus was born the story of money
For many thousands of years, that was enough. Money, in some form or another was good enough to make market places work, and kingdoms and empires run. Then came the spice rush!
The second derivative of value — the Joint stock company
When people wanted to sail thousands of miles in order to get spices from the East Indies (actually Sumatra, Java and Indonesia), they needed to get enough money to build fleets of ships, hire hundreds of sailors, buy thousands of beads to sell to the natives, and muskets and swords to take from the natives what they could not buy, and…well you get the point. The people who wanted to buy spices needed a lot of money. It was so much money that even rich merchants did not have enough.
Thus was born the first stock issuance, where people raised money by selling shares in a shipping enterprise. One of the first of these entities was the Dutch East India Company.
The purchasers of stock in a company got the rights to receive a portion of the money that was generated by the sale of spice. So the value that was generated was the spice, which in turn yielded a derivative of value, which was money, and the buyers and sellers of the stock of the Dutch East India Company could said to be trading in the first derivative of money, or the second derivative of value.
Now this imposed more costs. Shares and stocks of a company needed to be tracked. Legal systems needed to be made to account for this new thing called a company. Books of accounts needed to be maintained. Armies of clerks were suddenly needed to write these accounts.
But the benefits of pooling capital were undeniable….and the second derivative of value was here to stay
This was good enough for the capital market-place for the next 300 years or so. Then sometime in the 1950’s and 60’s a bunch of people started wondering if the stock of companies being exchanged really correctly reflected the “value” of a company.
And they noticed something odd. The more stock of a company changed hands everyday, the better its “value” seemed to be. This seemed to be because a larger number of buyers and sellers seemed to somehow correlate to more information about a company feeding into the market place. The reasons are too complex for this post and will need a separate set of posts altogether, but suffice to say, greater liquidity seemed to encourage better pricing.
The Third derivative of value —- Future and Options
So someone came up with an idea. How about we create a product called a derivative, which will be separate from the stock of a company, but will be based on the “Value” of the stock of the company. A whole gaggle of products, futures, options, calls and puts, and Interest Rate Swaps suddenly came into existence, and the world of markets was changed yet again.
The futures and options market imposed still more costs on the now vast financial market-place. A whole new breed of speculators came into being. A brand new vocabulary needed to be invented. Whole hordes of lawyers were sacrificed in the drafting of the first derivative contracts, before an industry was formed that specialised in trading these new and exotic creatures. Words like all-inclusive finance cost and cost of hedging came to bedevil CFO’s of otherwise normal companies.
In fact the derivatives markets in most stock markets now are 5-10 times larger than the underlying stock markets.
But even so, the benefits still seem to overcome these costs. Stocks can be traded quicker, pricing is quicker, and the wheels of finance needed to be greased generously with the lubricant of derivatives for them to function correctly.
The beginning of the next wave — Credit Risk
Now the tale starts getting a bit murkier. A mere dozen years after the first derivative contract was born, derivatives of derivatives start getting traded. However, they still track (in some form) the underlying value that companies generate, and therefore still were related to the core of the barter system, which was the exchange of value.
Now, some extremely intelligent people asked the next question….is there some way to get rid of the risk that is generated by the process of generating value?
Now a step back to explain. Value is generated by people making goods and services that they hope other people will have a use for. But there is always some risk that is generated when people engage in this process. Maybe unseasonal rains will harm a wheat farmers harvest. Or a fire at a factory could ruin a company that produced widgets.
With so many people now trading so many products that only derived value from the underlying company people started to worry that perhaps the risks involved in running a company were not being appropriately priced. Thus was born the concept of the Credit Default Swap.
The wheels start coming off the wagon — the fourth derivative of value
The idea of Credit Default Swap (CDS) is deceptively simple. In case someone fails to make a payment of debt, the Swap will act as insurance for the holder of that debt. The buyer of a CDS buys insurance, and the seller of the CDS takes on the credit risk.
The idea now is that the seller of CDS now takes the final step of evaluating the credit risk that may face an entity, and by pricing the CDS appropriately, the cost of money (first derivative of value) for a company (Second derivative of value) would drop, which in turn would make the product more fairly priced (generating more value).
Everyone wins! The CDS will never need to lose money because the insurance that is sold is always sold only after the credit risk is clearly mapped out, and the company gets to lower its funding cost because of increased certainty. What could go wrong?
As it turns out….lots can go wrong now. The additional complexity now involved is now so high that it is extremely difficult for the system as a whole to now generate more value than the added complexity. Sure, and individual CDS seller may be very good at pricing risk, and therefore could probably make money. But the various components that make up credit risk are too many to know with certainty, and now the structure starts to wobble.
Collapse and the destruction of Value
Any mistake in pricing risk will either increase funding costs of a company (thereby making its product unviable) or will hide the risks involved in the company (which will lead to a sudden catastrophic failure at some point in the future). Both of these things will tend to destroy an otherwise value generating entity.
More seriously, because of the large costs imposed in the entire value creating process, the failure will tend to affect not only the producers and customers of the goods being produced, but investors, traders and buyers of every derivative product the entity has linked to.
This is bad enough if the company is a large conglomerate like a GE. But what if the entity that is being affected is an entity that actually creates money; ie: the banks who create money by lending money and accepting deposits (another extremely long blog post required to explain the mechanism).
When banks get the price of their risk wrong, the chain of events that occurs can appear to be a reinforcing feedback loop which will eventually lead to the entire system of money that the bank depends on to shut down (at least temporarily)
This view of the market-place is one that I find useful to try to understand how individual items in financial markets move. By no means is this the only way to try to understand financial markets. In fact, its very likely this is not even the correct way. After all, CDS being a fourth derivative of value sounds like quite a stretch!
But the underlying point that each strand in the web of financial complexity adds costs, while delivering some benefits. it is when we weave too many strands that the costs can bring down the economic system.
Does this mean that complex financial products should be prohibited? I honestly do not know. My own thoughts are that rule based systems tend to be too inflexible to work in a changing world. But I have been wrong before, and could be wrong again.