This is an excellent resource and a great read, but DAMN do money markets seem stupid as all get out to me. Where is the productive output of all these arbitrage shell games? How is this more than an abysmal waste of time and resources simply to make a small handful of bankers richer?
I’m the author. Thank you for saying it is an excellent read — that was no small amount of work.
You ask “Where is the productive output of all these arbitrage shell games?”, which is a very fair question. The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them. E.g., you are not the optimal person to hold the risk that, through no fault of your own, your house burns down. That risk exists, and you are not the optimal holder of it. Hence insurance. A Lincolnshire farmer — and yes, I like the non-abstract solidly of the example — is not the optimal holder of the ‘risk’ that the Australian and Kansas wheat harvests are super-bountiful. Markets allow that risk to be transferred to a non-farmer better able to hold the risk.
Of course, with markets come some ‘unproductive’ stuff. Likewise, democracy is good, but that is not necessarily praising the optimality of all parts of campaign finance legislation.
Let me also mention that I am the author of the definitive reference book on old Vintage Port: Port Vintages (and seemingly the board disallows a link).
> The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them.
That is just one of the purposes; others are:
- time-shifting of consumption: borrow when you study or build a house, then invest and save during work years, then live of retirement portfolio
- maturity transformation enabling investment: extra cash goes in the bank (and can be redeemed on demand), is bundled and lent (long-term) to fund construction or businesses [1]
- allocative function: send capital to its most productive use. For that, you need accurate prices, supported by equity research and markets.
So, in real financial markets, all the arbitrage games etc. [2] at least support actual productive purposes.
In crypto, it's just a pure cargo cult copy of financial markets without any underlying productive purpose.
[1] that whole banking business is somewhat precarious, but reasonably well understood (since Bagehot) and regulated/insured, though in recent times obviously hasn't worked great. Alternative models (narrow banks + private credit) are conceivable.
[2] and to be clear: the amount finance skims of the economy is way too large. Similarly, building a somewhat straighter fibre (and then microwave towers) from Chicago to NY has no societal benefit I can discern. (But the solution to that is fintech and regulation, not crypto.)
Because whilst crypto provides an excellent solution for the "how to skim money from the economy by persuading less skilled investors to give you money" part of finance, it doesn't address the actual problems finance purports to solve like sending capital to its most productive use, maturity transformation, insurance, pensions etc.
The "social stack" is what actually makes finance's "application layer" happen, because it turns out that blockchains can't actually enforce delivery of barrels of oil or sue ICO recipient for spending their proceeds on coke and hookers, and things like hiring and receiving goods and valuing insurance losses all involve counterparties.
Much as you would like to personalise this debate, it's not about my level of agreement with straw gatekeepers. It's about the simple fact the "application layer" doesn't exist. You're not getting your mortgage or pension from a blockchain.
Nobody is saying delivery of assets is done on chain.
That's a strawman you've skewered twice already, well done.
What we're saying is: a lot of the low level infrastructure used now in finance (brokers! Dealers! Clearinghouses!) is easily replaced by some code, once you have trustless decentralized computers. Which we do now.
Then your oil barrel market is just some code nobody needs to trust, and yes, the "last mile" of it still needs "guys with guns" infra. So what? We made a part of that market freer and fairer.
You started off asking "why do you still want the guys with guns solution" and insisting that blockchain provided a "trustless, decentralized" solution to the problems financial markets purport to solve.
So I don't think it's a "straw man" to point out the answer to your question is market participants want promises actually delivered upon which you now admit is entirely dependent on the "guys with guns" (and/or trust). By extension, blockchains don't actually provide a trustless or decentralized solution to the actual problems of finance. Actually knowing that your counterparty will send you oil isn't some unimportant detail of the oil barrel market which can be handwaved away, it's considerably more important than the implementation detail of the transaction record updates or whether brokers are involved.
You've moved more goalposts in this discussion than crypto has moved in the useful bits of finance.
No. Here's the quote I responded to originally, slightly expanded for your convenience and ease of use:
> Similarly, building a somewhat straighter fibre (and then microwave towers) from Chicago to NY has no societal benefit I can discern. (But the solution to that is fintech and regulation, not crypto.)
I've always been talking about technical infrastructure, you're the one who brought up delivery of oil barrels.
If you think this bit is not important enough that's fine. Feel free not to get involved.
If you're purely focused on the GP's suggestion that the extra liquidity permitted by HFT might not generate enough benefits to the entities engaging in productive activity to warrant trading-specific infrastructure like dedicated fibre lines, you shouldn't even have needed to ask why he didn't consider this to be solved by a tech stack that uses the electricity consumption of a medium sized country to allow people to traded purely speculative synthetic assets :D
(even a blockchain not computationally inefficient by design wouldn't stop arms races to be first in line to accept the trade, or the incentives to do so existing. At least regulators have the theoretical power to make life difficult for certain types of market participant)
The GP's wider point was the purpose of the finance industry is to facilitate real world productive activity. If the "decentralised" bit is isolated from that, you haven't got a decentralised alternative to financial markets.
All those levels of infrastructure already run on code. There's no tech reason that Robinhood can't sell you stock that it holds. The FTX situation shows you why they aren't allowed to do that.
You have to trust that the restaurant where you're having lunch will accept BTC as payment. In reality, using Bitcoin requires the same trust-based infrastructure as everything else because the only way to buy anything with it is to trade it for fiat.
sure, and 1 UST = 1 UST, but it turns out that people who thought they didn't need to trust the asset held its value are considerably poorer than they were before.
By referring to arbitrage as “games” OP’s comment has poisoned the well for this entire chain of responses. So to get an understanding, first we need to fix.
A “game” implies non-productive or zero sum.
By definition, an arbitrage is not that. Any arbitrage is the result of an inefficiency in prices or the economy.
When someone arbitrages prices back to where they should be, they are performing a service that everyone else benefits from, and are rightly compensated for this. Now, are finance people compensated too much for correcting price discrepancies? If yes, then that’s another arbitrage opportunity!
But the question of what would be substantially different is easy. No arbitrage = no markets = top-down command economy. Check out North Korea, Cuba, USSR, the former Yugoslavia, etc. for what would be different.
> When someone arbitrages prices back to where they should be, they are performing a service that everyone else benefits from, and are rightly compensated for this. Now, are finance people compensated too much for correcting price discrepancies? If yes, then that’s another arbitrage opportunity!
While I agree that finance serves a useful purpose, I don't understand this bit. Suppose hypothetically that arbitrage gives some social utility, but not in proportion to the amount of money it makes for arbitrageurs, and thus not in proportion to the effort put into it. Suppose that society is overproducing finance -- that most people would be better off if the world had slightly worse pricing information, fewer financial datacenters and low-latency microwave links, less human effort devoted to banking, and more of something else that could be built with those resources and that effort.
Maybe this creates another arbitrage opportunity -- maybe in an idealized free market (where there are no barriers to entry) more people would work in finance, and their competition would reduce profits. But it seems to me that this would only worsen the overproduction problem.
Or is there something I'm missing here? Why isn't this really an "opportunity" to (carefully) increase taxes on finance, so that it won't be overproduced by as much?
I don't think it's the case that finance is over produced. If it were, then the value of financial services would drop.
Rather, because the gain produced by financial instruments is proportional to the wealth someone has, the returns of finance disproportionately benefit those with large amounts of wealth. One man can only make so much plumbing or being a mechanic, but can make an arbitrary about by investing in ETFs.
In other words, if the financial sector was largely a collection of small businesses run by middle class people, no one would think it was a problem that they make money. That would be great! But in reality it's a smaller amount of companies and smaller amount of wealthy people that benefit from it.
That problem isn't unique to finance, it affects many parts of our society.
> I don't think it's the case that finance is over produced. If it were, then the value of financial services would drop.
I don't think this follows for all financial services. Overproduction leads to a drop in value if the market is efficient, but real-life markets are not perfectly efficient. For arbitrage in particular, the whole point is that the market isn't efficient. Arbitrage makes it more efficient after the arbitrageurs have taken their cut, but the value of that service isn't necessarily determined efficiently. (At least as far as I know: I'm not an expert.)
> Rather, because the gain produced by financial instruments is proportional to the wealth someone has, the returns of finance disproportionately benefit those with large amounts of wealth. One man can only make so much plumbing or being a mechanic, but can make an arbitrary about by investing in ETFs.
> In other words, if the financial sector was largely a collection of small businesses run by middle class people, no one would think it was a problem that they make money. That would be great! But in reality it's a smaller amount of companies and smaller amount of wealthy people that benefit from it.
> That problem isn't unique to finance, it affects many parts of our society.
I think regulatory capture needs to be considered as well.
At some point those that amass large amounts of wealth are disproportionately able to influence government regulation to ‘game’ the system itself in their favor.
It seems in the realm of finance, it’s much easier to obscure regulatory capture than in other domains, where anti-competitive practices are much easier to suss out.
It's much simpler than that. The utility provided by arbitrage is that a given security is no longer under- or over-priced in one market relative to other markets. Any buyer/seller of that security will then always be buying/selling for the best available price (rather than losing out on money by not buying/selling in a different market).
The price discrepancy which was corrected by arbitrage is, itself, the compensation the arbitrageur receives. If it weren't, that inherently also means that there still exists a price discrepancy, and thus an arbitrage opportunity.
This is all separate from the question of public policy. Should taxes on income from arbitrage be increased? Perhaps they should. Though that doesn't affect the mechanics of how arbitrage works, it simply decreases the net profit of the firm doing the arbitrage.
Conceivably, you could increase the taxes/regulations/restrictions on such firms to such a degree that they are either no longer allowed to perform arbitrage at all and/or can no longer justify the cost of the high-speed equipment involved. The end result of this would be that the markets become less efficient (there would be greater price discrepancies and they would arise more frequently).
How much does that matter? Well, that's more of a philosophical question. How much does it matter to you that you're buying something for the best possible price (versus knowing it might be available cheaper elsewhere)? Depends on the person.
I understood it as it's an arbitrage because it enables the creation of a new system that reward arbitrageurs less (but still enough that they would perform the arbitrage).
Though this is only true in a system where you don't face tons of hurdles to deploy these new systems, which is not the case in the current financial system.
Most of the pricing inefficiency comes from information asymmetry. It might have made sense a 100 years ago when information traveled slowly. But in today's world, it travels fast. But still there is asymmetry due to purposeful obfuscation and complex packaging.
You‘d probably see much larger spreads and lower liquidity when buying and selling stocks or commodities/currencies; you’d often overpay on insurance etc.
(All assuming a properly working market without collusion, illegal usage of non-public information etc. – which is unfortunately not always the case.)
I was nodding my head along (fantastic answer) until the stab at crypto.
Let me offer a (partial) defense of crypto if I can:
Broadly, crypto is divided into crypto-currencies and applications.
Let's tackled currencies first, some of which some are reputable and some of which are grifts, but which viewed in their most favorable light attempt to be a form of currency or asset that is decentralized. This means that no single party may unilateraly devalue them, or restrict their trade in any way.
(No I understand if that doesn't excite a lot of people, but this is clearly valued by some people!)
As may be obvious, crypto-currencies are too volatile to serve as actual "currencies", so they are at best "assets". But it is possible to use these assets as collateral for the minting of stablecoins. I'm not sure this is quite risk transfer, but it essentially relies on the willingness of some to hold speculative assets to enable the creation of a stable assets.
In turn, these assets are not typically useless — they hold value because there is demand for them to pay for transaction costs on blockchain.
Blockchains themselves are not useless. We may not think much of the difficulties of transferring money, but it is a real challenge in LARGE swaths of the world, where people are unbanked or live under tyrannical governments. I would argue that even in the west, the need becomes is becoming more pressing (Trudeau freezing trucker supporter bank accounts, banks imposing tons of restriction on cash withdrawals and "large" bank transfers).
Beyond transfer, they also serve to run decentralized applications. People are quick to dismiss those, and true it doesn't enable to do anything dazzingly new. It simply enables you to do things you could already do, but in a way where no single party (or even colluding parties) can shut it down. This may seem silly, but I think the world would truly be better if we for instance had a YouTube where copyright trolls couldn't strike down / demonetize legimate content.
Applications then. In reality, we're still far from decentralized YouTube (but we will get there). Most applications today are financial. And I think they're quite useful. The financial infrastructure being built is genuinely novel and useful.
The problem is that it is navel-gazing at the moment: that infrastructure is mostly used to perform financial operations on crypto tokens themselves. But there is no reason that they couldn't be used for other assets.
In fact this is starting to happen: you can now invest in real estate and US treasuries on the blockchain. We're still a way from mainstream adoption, and that has mostly to do with legal uncertainties that prevents established players from diving in (though many of them are experimenting). There are also entrenched interests there, it must be said.
So if anything else, crypto helps build a better financial infrastructure.
It's somewhat ridiculous that when you buy some stock, the trade is routed through three intermediaries and is only really settled 7 days later. The abstraction on top of this is actually leaky, with each intermediary coming with some risk and some agency to throw a wrench in the works. As in fact happened between Robinhood and its clearinghouse (or some such intermediary) during the GameStop frenzy.
Heat pumps will take a long time to reach every application that needs heating. EG: drying grain. Sometime heat pumps are not the answer (-21F for instance). Bitcoins resistive heating properties are almost 100% efficient.
With bitcoin mining: Money In = Heat + Air Flow = Money Out.
Electrical energy now has an opportunity to not be waisted where it normally would be. Think renewables where line loss / demand doesn't make a perfect system. Bitcoin can act as a storage device with near free movement allowing flexibility in these systems.
This monetary recovery can also be used to move money/energy to other places without the line loss.
It’s that last step I’ve never understood. I get that some guy in Iceland has excess power generation and can use that to mine bitcoin. I can then buy those bitcoins from him. However, I’ve never heard an explanation for how I then recover the energy from the bitcoin?
The closest I’ve heard is that I could use the bitcoins to buy electricity from someone else, but I could have just paid that guy in the first first place and cut out the guy in Iceland. Also, it feels like we now have two power plants involved in charging my laptop, which feels like a lot of overhead.
I’ve heard this explanation enough that there must be something obvious that I’m missing.
You could take the bitcoin from excess hydro generation in a northern climate and deploy solar panels in a climate where solar has great ROI for instance.
Note also that in some cases you might be the optimal person to hold the risk that your house burns down, if, for example, your liquid net worth is 100x the replacement cost of your home. And that's illustrative of the value of markets: you can choose to transact in them, depending on your personal circumstances. The insurance market exists because for the vast majority of people, rebuilding their home is not feasible with their current net worth. But for a small number of people it might be, and for a small number of firms it's probably worth it to insure many thousands of people, and then you can even slice up the shares of those insurance firms and sell them on the stock market so that the risk of your house burning down gets socialized across all the other shareholders but at the same time you have a stake in the profits.
Rebuilding a shitty house is quite possible for a person. Like people can literally build simple shelters in a time frame of hours. It's only because of so many regulations and rules that you have to go into multi-decade debt.
For instance, apparently the EU is currently considering a regulation that houses must be energy efficient. Getting a current house into compliance would cost on average $50k. That kinda stuff adds up.
Please point me to this law. Unless you are in a mortgage, no law requires you to hold homeowner’s insurance, and you can absolutely self-insure, to my knowledge.
The same is not true for auto insurance in most states, though most also have an option to self-insure by putting up collateral.
There may not be a law explicitly stating you have to have homeowner's insurance. But.
Without such insurance, specifically the "injury liability type" with its limits; then if someone gets injured on your property there may be no limit to your liability.
So even people who could afford the loss buy insurance because it is the best method of limiting intangible risks.
My understanding is that for an LLC to provide protection the house would have to be used for purely business purposes and that there can be no co-mingling of personal finances. the concept is called "piercing the corporate veil". IANAL but I looked into this pretty extensively when choosing how to protect myself with investment properties.
It definitely shows, thank you for publishing it freely
>The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them.
This makes a sense to me, thanks for explaining. I can definitely understand how insurance collectivizes and smooths individual risks, and from this and other examples I can see why a lending institution might seek something similar to enable them to keep cash moving. It does seem a little epicyclic to me that a farmer faces a glut as a result of organizing food production through a market economy, and then we resort to like a second-order market trick to resolve that problem. Presumably it would be simpler to just dump all the food in the middle of the table and then hand it out evenly, but I've heard this runs into its own set of difficulties.
>Let me also mention that I am the author of the definitive reference book on old Vintage Port: Port Vintages
Very welcomed, I may not buy the book but I will definitely go buy some port. TGIF!
> A Lincolnshire farmer — and yes, I like the non-abstract solidly of the example — is not the optimal holder of the ‘risk’ that the Australian and Kansas wheat harvests are super-bountiful. Markets allow that risk to be transferred to a non-farmer better able to hold the risk.
Are you familiar with the arguments of (more popularly) Aaron Brown and (transitively) Jeffrey Williams?
Essentially, the idea that a farmer would be an active participant in a futures market is quaint, but the vast majority of activity is speculation. This is not a contradiction of your point, but an elaboration of a counter-intuitive part of it.
One might look at a futures market and see that well over 98 % of the activity is buying and selling by people who never have any reason to care about wheat other than for the possibility of its price going up or down. But this large-scale speculation is precisely the thing that makes it possible for a farmer to hedge (by providing liquidity and a motive for the counterpart of the hedge) or, as Williams' points out, perhaps more commonly "take out loans in commodities" for their convenience yield.
Essentially, the Lincolnshire farmer can lock in a price with a plain forward contract. However, that does take a double coincidence of demands (or whatever the phrase is) and the standardised nature of futures contracts help avoid that problem.
But! The most common use of futures contracts (aside from speculation) is not (or at least was not, when Williams wrote his book) hedging, but effectively borrowing and lending in commodities.
Where do you draw the line between (useful) arbitrage and "pure speculation"?
Much of what is commonly known as speculation is actually an important mechanism for price quality or liquidity.
Obviously there are limits, and there are ample opportunities for making a one-sided profit without regulations, but people often seem to miss the value that arbitrageurs tangibly provide to them: Being able to exchange foreign currency at very tight spreads almost 24/7; being able to buy and sell even not commonly traded stocks etc. are often a function of that.
I think you and I are saying the same thing! What's counter-intuitive about many well-functioning markets is that the vast majority of what happens is superfluous in one sense, but its side effects are desirable by most!
It is an interesting reframe to think of insurance as a, roughly, ATM put.
Having some experience with both trading derivatives and gambling though, I’m fairly confident saying that it’s a distinction without a difference. In both cases a little guy with an understanding of risk and bankroll management and some aptitude for the game, which for trading is a Keynesian beauty pageant, can scrape up a few bucks. But most people are going to be fish for the house. The derivative markets are providing exactly the same service as casinos, albeit with considerably higher limits and opportunities for crafting complex bets.
The derivatives market is like if they let you buy insurance on anyone without ah insurable risk.
So I could decide that I think your house is likely to burn down, so I buy insurance on it.
That's what enables the gambling. If the only people who could buy puts or calls were people who had insurable risks in the underlying; it would be a lot smaller market and less gambling.
Regulating participants to only those who have a purpose and meaningful reasons, would mean higher bid-ask spreads, less liquidity and less turnover, which then means those markets would probably cease to exist. Gamblers in these special markets are a net-positive, non-gamblers are happy to give some gamblers a payday or some drink money, since it allows non-gamblers to focus on their main activity, instead of doing their activity and gamble that everything turns out fine.
> So I could decide that I think your house is likely to burn down, so I buy insurance on it.
which makes the insurance premium grow higher, reflecting the information that such a house has a high risk of burning down.
It doesn't matter that the buyer of the insurance has no material connection to the house. I can't see why such "gambling" shouldn't be allowed to happen, provided that there's enough regulation and monitoring so that you cannot then go and burn down someone's house to collect the insurance!
casinos are based on pure chance which nobody cares about (what does it matter to the outside world if a coin came up head or tails?) and the house still takes a cut.
financial markets are based on stochastic events which do matter very much, such that paying a broker is worth it. If it's not worth it to somebody, they should not participate, but in that sense they shouldn't participate in casinos either.
Some derivatives can be fairly consistently good bets, because you can take real-world probabilities, while your counterparty (the bank) deals with "risk-neutral" probabilities implied by their hedging, which can differ quite substantially and persistently from the real-world probabilities.
I would love to hear your opinion on Silicon Valley Bank and First Republic Bank. Did they deserve their fate on equal terms and also in retrospect who should have been the optimal holder of their risks?
> who should have been the optimal holder of their risks?
they _produced_ more risk (by holding long maturity bonds that lose value as interest rate grows). This risk was not something that is inherent - they could've chosen not to do that with the large deposits from the pandemic money growth.
There's noone who can be the optimal holder of the risk that is produced this way, because there's no value on the other end - SVB is taking the full value already (the interest payments on said long bonds).
If someone were to hold that risk, SVB would have to pay out premiums that would surpass the interest income they receive.
The alternative is for society (aka, the central bank) to hold that risk. But this just means socializing the losses but privatizing the gains - something i'm very much against.
In the end, SVB was the optimal holder of the risk (that they produced for themselves). And they can't actually hold that risk - thus their failure.
I know less about FRB's failure. It was likely due to a domino effect from SVB's - specifically, FRB has a high uninsured ratio of deposits (they service rich people).
The FDIC has announced that they will not do a repeat of what they did for SVB - insure the full deposit amount rather than just the $250k. Therefore, anyone with a large deposit in a small bank is going to want to move their money out into a "too big to fail" bank.
Unfortunately for FRB, this is what happened to them. No bank can survive a real run, no matter how carefully balanced they are with risk (after all, they _do_ take on some risks in order to make a profit).
In my opinion, the FDIC's announcement of what they will not do (insure the full deposit, even if above the $250k limit) after doing it for SVB, while have good intentions, is what backfired.
They should've just lied, and said that they'd do it for another bank, if there's a need to; this would've stopped any fear of a run, and thus stop the run before any more dominos collapse.
> They should've just lied, and said that they'd do it for another bank, if there's a need to; this would've stopped any fear of a run, and thus stop the run before any more dominos collapse.
While this may have prevented FRB, that's a very dangerous game to play should the bluff get called.
I'm strongly opposed to the idea that those given the power and authority to control or markets, as best they can, should world that power by lying to us. Lying because they think it's the best thing for us or because they don't think we can handle the truth is a slap in the face to the very trust that empowered them to begin with. Our leaders do this often and it's such a slippery slope - it either works and you feel emboldened to lie again or it backfires and we're all worse off.
The thing is, this white lie is what keeps confidence levels high, which is what prevents the run.
By merely suggesting that a bank can fail, and that the FDIC is not going to bail out high depositors, they paradoxically _cause_ the run. After all, the people who took the money out just merely redeposited it back elsewhere (that they trusted more).
The white lie is better than a loss of trust which lead to an actual problem. And the FDIC could actually lie without lying by putting in vague words and misdirect people - such as saying things like "if necessary". In fact, people in society today believe plenty of white lies already - what's one more?
While I totally agree that is how the system is designed, that's also the fundamental issue I have with it.
If we have such a fragile banking system that those in charge are expected to lie to us to keep people from seeing the fragility, we have to rethink the system.
> In fact, people in society today believe plenty of white lies already - what's one more?
That feels like a bit of a slippery slope, selling people on one lie shouldn't justify telling another. It also means first defining what a white lie is, and who gets to know the truth to decide whether it's acceptable or not.
Except that is not exactly "productive", isn't it? After all, risk was not eliminated, only redistributed. Productive output, e.g., would be something that reduces the chance of your house catching fire.
The redistribution is productive, because by redistributing risk (not just among people, but also across time), some ventures that were otherwise not feasible become feasible. For example, you want to build a house - but you don’t have the cash. A bank gives you a loan. They take the risk that you won’t pay them back, you get a house, and return they get a premium. This benefits many stakeholders (you, the bank, the builders, etc). If the bank has too much risk, they can off board it to someone with deeper pockets and a more diversified portfolio.
> If the bank has too much risk, they can off board it to someone with deeper pockets and a more diversified portfolio
... or especially to somebody who happens to bear the reverse risk.
For example, a wheat farmer doesn't want the risk that wheat prices might collapse by harvest time due to windfall harvests somewhere else in the world; and the spaghetti maker doesn't want the risk that wheat prices might be soaring due to crop failures somewhere else-else. They make a deal now so they don't need to worry about the future, but they don't need to make the deal directly, they can each buy or sell wheat futures.
I am not saying that the redistribution of risk is not useful —— it certainly is, and I agree with what you said. But let us suppose we would like to reverse climate change at a global scale in a short time without further damaging the environment, right now; I don’t see how it would be possible with our current technologies, even if every possible risk redistribution options are exhausted.
This is exactly the why and how of "travel broadens the mind". You only have to visit countries and socities that do not have well-developed financial markets to directly see and appreciate the value financial markets bring to your own society.
Visit a part of the world where most people do not have access to home loans, health insurance etc. and you will not have to ask how mere redistribution of risk and capital adds to productivity ever again. (I happen to have been born one such part of the world.)
> socities that do not have well-developed financial markets to directly see and appreciate the value financial markets
Which is true, but there's another angle that needs discussing - that of a high-trust society vs low-trust society.
In all places where there are well functioning financial markets, there exists a high trust society. This trust is the foundation on which the financial markets exist.
So in poorer countries where such financial markets don't exist (or don't serve the people), it's not because they've chose not to have it, but that individual actors cannot trust that the system is fair and is rules based. So the problem isn't the lack of financial markets (which is a symptom), but that of a lack of good governance (bad or non-existant laws, corruption etc).
Rural India (unlike urban India) is relatively high trust environment. Everybody knows each other and there are lots of shared ethical values. But they still have to build their houses one brick wall at a time (lack of access to home loans) and be at the risk of financial ruin due to unpredictable life events (lack of access to insurance).
Urban India is a very low trust environment, but people still have access to things like home loans, insurance and capital markets (equity and loans).
> lack of good governance (bad or non-existant laws, corruption etc)
I agree that good governance is a necessity for development of financial markets, but not sure what it has to do with being a high trust or low trust society.
i would imagine that high trust but only within the village is not really high trust. Anyone outside the village who would've otherwise had the capital to lend to this village would not trust them to repay the loans, and perhaps would also not trust that the authorities would come in to enforce the collection of collateral (and in any case, if you forcibly evicted the original owners of a property for debts, the other villagers are probably not going to let you live there peacefully).
> but not sure what [good governance] has to do with being a high trust or low trust society.
Good governance allows high trust to exist, which allows many other things to exist as a precondition.
Many businesses would behave much more conservatively -- making much smaller bets, conserving cash instead of investing it -- if they could not offload certain risks. So that ability does increase overall productivity IMO.
Sure, but without insurance, everyone would have to have enough cash available to build a second home in case the first burns down (ie, provision for the worst case loss). With insurance, just need to have extra cash corresponding to the expected loss (ie, worst case loss times probability it happens) plus some cost for administering the insurance.
So, effectively [1], with insurance everyone can build a house nearly twice as big as without. That strikes me as productive.
[1] if the probability of a fire is sufficiently small
Risk, for many things, will never be eliminated. They can only be reduced and/or redistributed.
For example, having fire sprinklers greatly reduces the risks from fire. However even the reduced risks are still too great for your typical homeowner, so therefore those risks are distributed (and the reduced risks are reflected in lower premiums for the homeowner).
Why have them privately controlled at all? The fed prints the money. The fed could be the bank and insurer as well, and obviate the middle men skimming the pot.
Because private insurers have incentive to accurately price risks. If they price them too low, they will go bankrupt. If they price them too high, the competition will steal their customers with lower rates for the same coverage.
The governments, on the other hand, don’t go bankrupt, so when they price the risks too low, the public will be forced to bail it out anyway, either through taxes or through inflation.
This very much is real and serious problem: consider, for example, National Flood Insurance Program, which is exactly the kind of publicly controlled insurance you asked for. It was $25B in the red by August 2017, and would have gone bankrupt if it was private. However, you (and other taxpayers) bailed it out in October 2017 to the tune of $16B. It continues to accumulate debt, and is more than $20B in debt right now. You will bail it out again, and keep subsidizing people who build their houses on flood prone areas, knowing that you will pay for their losses.
It's no different from the GFC, where the risk (of those mortgages) are mis-priced, and in the end, someone is left holding the bag.
A functioning market to redistribute risk needs transparent pricing, and proper bankruptcy (so in other words, the risk taker must not be bailed out, even if it hurts in the short term).
I think that just invites parasitic loss into the system through profit seeking, but maybe this is in fact by design, and us laborers are merely a means to another's greatly yielding end.
> The default should be the government doesn't do things
Right, but taking this in the opposite direction then, why for public interest things should the default of 'people who just want to buy the next yacht' run them good?
Unfortunately "running it good" might also mean things like bain capitalism where they part out anything of value and leave the customer base high and dry.
Yeah, capitalism 101, good in theory but terrible for most people in practice. Look at e.g. the health system, where a major issue means total bankruptcy and life debt. A somewhat balanced system where governments protect basic needs and have some control over the markets is the ideal imo.
I think you did a great job of explaining why someone might want each of these products, starting from first principles of "a company borrows some money from its bank". To still ask GP's question is either to not have understood the book, or to not understand any scenario where one might want to lend or borrow money.
As a beginner book, no there are no substantial changes on what a beginner should read.
However, while the simple discounting formulas described (likely, haven't read other than the list of contents) in the book were at the time actually used more or less as-is to value instruments in the derivative markets, nowadays they are seldomly used on their own. Two major developments there are multi curve discounting taking collateralization into account and different valuation adjustments, collectively known as XVAs.
That is not to say you do not need to understand the beginner basics, vice versa, iys just that nowadays there is much more nuance in actual valuation.
Edit: to add, I'm not sure if its useful to study these nuances in detail, unless you are going to actually work on the markets. In the big picture their details are likely not worth it, but of course it is good to try to understand why these developments have been needed/wanted by market participants.
I had wanted to work in markets, but my GPA (& now post-grad resume) didn't quite work out for it. I don't do well in the lecture-homework format. Nonetheless I'm interested in the minutiae, so thank you for the elucidation!
There’s a free HTML version on my website, which has some green-boxed updates. But even without those, the book is an excellent beginner’s guide to the interest rate markets. (I am the author, so might be thought not to have a NPoV.)
Prices and financial markets in general exist solely for information transmission. The central problem of economics is "How do you produce the things that your population needs, in the quantity and at the time they need them, as efficiently as possible?" This is why every centrally-planned economy eventually fails, and why we were stuck in the feudal middle ages for a millennia. Information (and incentives) about what to produce and how to produce it efficiently weren't getting to the population at large, which caught us in a local subsistence minima. Financial markets give all the players an incentive (in the form of profit) to transmit information (in the form of prices) from people who want goods to people who can supply them.
This is also behind the theory of why certain forms of financial transactions are legal and others are illegal. Arbitrage = legal, because it converges prices in two separate markets in a way that gives producers in both those markets better information about true demand. Futures markets = legal, because they smooth out temporal fluctuations in demand so that producers only have to worry about producing, while also incentivizing the construction of just enough storage & buffering to hold that product. Pump & dump schemes = illegal, because they distort price information in the market in an unsustainable way and then leave later participants to bear the cost of this. Same with Ponzi schemes. Equities markets = legal, because they transmit information about the overall cost of capital within the economy to firms, which can then use it to decide the profitability or unprofitability of various investments.
Certainly one function of financial markets and prices is to convey information, but that's not "solely" their purpose. They also provide a mechanism for resource allocation, risk management, wealth generation and collective action, among other things.
Your point about centrally planned economies, while historically corroborated in cases like the Soviet Union, might be an overgeneralization. The effectiveness of an economic system depends on numerous factors, including its degree of flexibility, the effectiveness of its institutions, and its ability to adapt to changing circumstances.
Not all centrally planned economies are doomed to failure; some have been quite successful, notably in East Asia where countries like China and Vietnam have managed a mixed economy with elements of central planning and market mechanisms.
Many capitalist corporations are centrally planned economies larger than many nation states. While everything fails eventually, these centrally planned organizations can last multiple human generations, and can be more durable than many markets and market-oriented economies.
The assertion about the feudal Middle Ages also needs some nuance. The Middle Ages, and the feudal system in particular, had complexities beyond simple information and incentive problems. Numerous sociopolitical factors were at play, including a rigid class structure, the influence of the Church, and the lack of certain technological innovations. Ascribing the issues of a historical period mainly to its economic structure oversimplifies the multitude of factors that influenced societal development.
Moreover, while financial markets do help in transmitting information from consumers to producers, they are not infallible. They can, and often do, suffer from issues like information asymmetry, where one party in a transaction has more or better information than the other. This can lead to problems like adverse selection and moral hazard. Financial markets can also be subject to speculation, which can distort the "signal" provided by prices.
The focus on profit as the sole incentive in the market might be somewhat limited. People's decisions to buy, sell, and produce are influenced by a host of factors beyond profit, including societal and environmental concerns, personal values, and ethical considerations. Financial systems, to be truly effective, need to take into account this wide range of motivations.
Resource allocation, risk management, and collective action are all information transmission problems. It's arguable whether wealth is being generated by the people who actually do the work or the people who decide what work is being done, but that's the subject of this thread.
China isn't really centrally planned. They call themselves that so that the government and previous communist ideology can avoid losing face, but anyone who's visited there or done business with Chinese companies will say that it's intensely capitalistic, just with the potential for random state interference at a whim. I suspect the same is true for Vietnam, but know less about the country.
Information asymmetry issues are exactly why certain types of financial transactions are illegal - that's why we have things like SEC disclosure and insider trading laws.
Why is it that every time someone mentions futures trading someone comes along to drop the farmer's crops example, do y'all really have no other examples?
What percentage of futures trading is on farmers crops?
What about the crops they destroy because they would be less profitable? Does the protection against monetary risk outweigh starving people to death?
How well will it work if we create unsustainable land that the farmers can no longer grow crops on?
I don't have a percentage for you but agriculture-related futures make up a non-negligible amount of overall trading. It's not just some artificial example. Agricultural futures were also the first futures, and much of today's trading infrastructure was built around agricultural futures. So that's probably part of why it is such a common example.
They are far from the only example. Airlines use futures to hedge against fluctuations in fuel prices. Manufacturers use futures to hedge against fluctuations in the price of input materials. International businesses use FX swaps to hedge against currency fluctuations. Borrowers use interest rate swaps to hedge against interest rate rises. Investment funds (including pension funds and sovereign wealth funds) use options to hedge against drastic movements in asset prices.
I don't really understand your other questions. The use of derivatives in agriculture does not, on balance, result in fewer crops being produced. On the contrary, by allowing farmers to protect themselves against various risk, derivatives markets allow farmers to safely invest more money in production, and reduces the risk of farmers going bankrupt (bankrupt farmers don't produce many crops). Food would almost certainly be more scarce and more expensive if farmers did not have access to the financial markets.
Because farmers have been using futures contracts (traded on an exchange) since 1859.
And technically, futures are a more standardized tool than forwards are, hence the talk about futures all the time. [1] For reference, forwards have been used forever, and used for all sorts of commerce. [2]
We take for granted that you can pull out an iPhone and buy your favorite stock in seconds, but for most of history, nobody could even imagine that. That the modern world even exists is because of forwards and futures. The ancient world was able to grow and expand because of forwards.
The one goal of future contracts is for producers and consumers to be able to make deals before that production and consumption happens. Those are the primary dealers there, and I don't really remember where I got statistics, but AFAIK, they are about 10% of the volume.
On top of those primary deals, a lot of people pile up making bets on secondary deals. Those are the people going for "hey, a lot more farms are growing rice this year, I bet its price will fall". They are very welcome because they not only stabilize the prices on those markets, but they also provide short-term money to make the deals flow more homogeneously. Without them, making deals on those markets would be a profession by itself (as it was).
Now, there exist people making bets on the results of the bets of the secondary market. That is a different market. At some point it's clear that this becomes toxic, but nobody seems to agree on what point exactly.
> What about the crops they destroy because they would be less profitable?
You mean farmers getting bankrupt? You seem to be misunderstand, because the main reason farmers love the futures market is because it lowers their risks.
> How well will it work if we create unsustainable land that the farmers can no longer grow crops on?
Well, surely if you go and kill everybody, there will be nobody losing money on those markets.
> What about the crops they destroy because they would be less profitable?
To clarify this point specifically, food self sufficiency is considered a national security issue.
Consider the situation where a hostile country floods your market with cheap food products (below cost) until your country's farms go bankrupt due to an inability to compete. Once you stop producing food of your own, you give significant power to whoever controls your food supply.
This is a large part of why agricultural subsidies exist. And yes, sometimes it means paying farmers to let crops rot on the vine in order to not cause market gluts. That is an entirely different situation from futures and hedging, which in any sane market match supply and demand (with the result of minimizing waste).
Not necessarily, if they can produce the crops more cheaply. Since each country ideally wants to secure it's own food supply, it's inevitable that many countries will find themselves subsidizing local production that would otherwise disappear in a competitive international market.
Additionally, hostile countries do not need to flood markets sustainably if the goal is simply to hollow out food production in the target country before taking more overtly hostile (i.e. military) actions.
Because it's an example you can use to explain a forward contract, which is easily understandable as a form of hedging risk. Vast amounts of the value of crops are hedged, either through forwards, futures or derivatives. Crops aren't destroyed because of hedges (in the financial sense). Indeed, the whole point is to ensure you don't need to, because you've hedged the value of your crop.
I get where you're coming from, and there's a lot which is not great in farming, but hedging values isn't one of those areas.
>Why is it that every time someone mentions futures trading someone comes along to drop the farmer's crops example, do y'all really have no other examples?
Because it was created by them, for that very purpose? Futures Contracts. Chicago Mercantile Exchange. Up until 1971 future contracts were ONLY for agricultural goods.
You’re right but in America we use the agricultural example as it was a big shift in our market thinking. I didn’t know about metal futures but I did know about Dutch and how they created futures and securities. I believe the Dutch East India Co to be ahead of its time and because of world politics (and war) it didn’t survive and was nationalized. A lot of papers about our CME here in the states talks about it. I’m not an expert but I do know we use the agri example because it’s one most would be familiar with since it was a somewhat recent addition.
It’s not just farmers. It’s useful for anything that involves future delivery of a good that could have a variable price or production.
A mining company would sell gold futures under the expectation that they will mine a known quantity of gold. They trade the risk of price fluctuations to match against their known liabilities (e.g. labor or depreciation of equipment costs).
Now replace “gold” with lithium (for electric car batteries) and you can create the greenwashed story that you want to hear.
The website gives the gold mine example. Farmers and gold miners often have to weigh taking on a loan to get them through next season. They want a fixed rate of return to determine if the loan is worthwhile.
> Why is it that every time someone mentions futures trading
They didn't just mentioned, they had an outsider negative take on it.
The best way is to respond with simple examples.
> What about the crops they destroy because they would be less profitable? Does the protection against monetary risk outweigh starving people to death? How well will it work if we create unsustainable land that the farmers can no longer grow crops on?
How does futures trading cause these negatives? If anything, trading reduces these risks. Countries with markets have large bounties as opposed to those that don't.
Because that’s what futures are for? Consumers and producers of commodities want to lock in prices to lower the risk of price fluctuations in the future.
Other examples are _all_ commodities markets like mining, logging, etc.
Of course public company share futures are inherently abstract, but they serve similar purposes, just not to a particularly similar party, depending on your perspective (of ownership, operation).
Not sure why this person is getting downvoted, these seems like fair questions.
Edit: Now get why it is downvoted, but it's fair to note that farmers represent a small (10% from what I gather here) portion of futures, so I don't know how reprensentative they are.
There is a societal benefit that comes with individuals internalizing their own costs of risk. Treating society like it's in an economic womb while Mother Finance shields it from the world of worries rewards ignorance and in my opinion accelerates us toward the world depicted in Idiocracy.
It is nice as a purchaser of such securities that you can build things more quickly than usual and transfer worry to someone who is willing to be worried for you. However I don't believe the SEC financial highway patrol has enough cruisers or sophistication to pull over enough abusers to deter the disproportionate fraud that increasingly arcane financial instruments create.
The costs of a few bad actors building piles of money illegitimately do not show themselves immediately. They pop up slowly, in dark money investments in destabilizing elections, funding of war criminals, market manipulation, etc. The societal cost of a charlatan having several lifetimes worth of an honest person's influence are grave and not to be laughed off.
I get why farmers do it but what's the societal benefit of letting a rando like me buy and sell (i.e. make bets on) such contracts? Do farmers really prefer that random people do this?
Theoretically, the societal benefit of lettings randos buy and sell contracts is that there is (a) better price discovery and (b) better liquidity. There are probably theoretical counterarguments to both of those points, but it's hard to see alternative systems that provide either or both those features.
At a basic level, obviously thee needs to be someone assuming the price risk from the farmers, and those people will obviously need to be compensated.
I buy that there's some benefit, but I don't buy that it's significant. And I don't see any reason why I should believe this provides a net benefit to society. Sure it saves the original parties some money, but then a bunch of unrelated parties come in and siphoning money from the existing parties. Why should I believe this is net-benefiting society?
The more something trades, the more likely we will have the right price. When things don't trade as much, we don't actually know what that thing is worth.
This concept is a benefit to society as many things are interconnected and correlated, so the more accurate we can quickly find the current price (and expected future price) the more we can evaluate value.
(Also, they aren't "siphoning money" really it's "value" because the contract isn't actually money)
Just because you've improved the accuracy of a price for something, that doesn't mean whatever you're doing to achieve this is a net benefit to society, right? Surely the idea that this logic doesn't follow isn't weird?
Is the idea that society gets a net benefit from price distortions like minimum wage, subsidies, taxes, etc. also "weird"? These also make it hard to discover the "right price" for goods, therefore it's... weird to have them?
My point about being "weird" was related to this bit:
> but then a bunch of unrelated parties come in and siphoning money from the existing parties.
I think you are trying to argue that markets mean that the value of a purchased contract changes, and that's only if you want to sell the contract again. If you buy the contract you'll get delivery of what you bought at that price? the market moving only affects you if you want to sell again. If I buy a 2009 used dodge charger with 100k miles for 10k, and then the next day someone sells another 2009 dodge charger with 100k miles for 9k, are those unrelated parties siphoning money away from me?
You could go straight to your local wheat farmer and cut a deal directly with them, but they are gonna say "what's the going rate for wheat" and call some friends and look at market data to determine if they want to accept your deal or not.
----
If you believe that futures markets are harming society, then what is your proposed solution as to how a buyer and seller should agree on a fair price for wheat?
In general/basics/origins, farmers only want to sell futures, because they actually have (intend to have) the commodity for physical delivery, and do want to physically deliver it.
So who is on the buy-side? Exclusively supermarkets/distributors, while exclusively farmers sell? I suppose that could work, but I assume it would quickly regress into tight relationships like we have (probably regionally variable) for smaller market's, like most vegetables (vs grain) where as I understand it it's largely a direct relationship with the buyer - you probably still sell a future contract, but it's not via a central market and it is 'farm x will deliver to buyer y', i.e. a pre-order if you will, not really a commodity.
And as others say, price discovery, liquidity. What harm does completely open (no obligation) do? And maybe you eat a lot of potatoes and want to lock in the price today. (Or more seriously maybe you're a big baker, but not big enough to be buying direct from farm, your miller is. So grain price affects you, but ypu can't directly control/choose when to take it. Secondary grain futures allow you to hedge risk of it moving against you. In turn this means lower prices or lower risk of shock price increase to your consumers.)
Farmer agrees to sell an agricultural commodity to a grocer, for a price fixed now, with delivery after the harvest. Assume price falls a lot, and then the grocer goes bust. Ouch! Then the farmer must instead sell on the open market, at the lower price, and so becomes unable to make the payments on the mortgage on the tractor. Ouch ouch!
The farmer did want the price certainty that allows the risk of being more leveraged (tractor mortgage). But the farmer was not the optimal person to hold the credit risk of the grocer.
And the farmer might have sold without the intent to deliver. It might be that the delivery specification, or location, or whatever, isn’t perfect for the farmer. But if the farmer is confident that the prices will move together, then it still works.
It creates the market and should thus create the best possible price. Think of any speculation as a voting system with proof of stake.
Problems always appear when market participants try to affect reality to increase their odds, like shorting a position and then releasing some ugly news.
It's doubtful that farmers care about you in particular. However, in general, the societal benefit should be like a loan, like insurance, or both, depending on what it is.
Loans are useful and necessary because businesses need to buy things before they get paid. It can't all be done using Kickstarter! Farming works this way.
Insurance is useful because you get paid when something bad happens to you. On a day when you're glad that you had insurance, it means someone else lost a bet.
Buying insurance you don't actually need is kind of dumb because you'll lose on average, but people do sometimes win in casinos, too. Selling insurance when you can't afford to lose is risking disaster, but sometimes people get away with that too.
I don't follow. If the goal is insurance then why not just have... something more like insurance? Like when you buy insurance for your car or home? We don't let randos buy options on the average Joe's mortgage or car loan and claim it helps price discovery or liquidity, right? Or is it the case that even I can do that and I'm just out of the loop?
To answer your question directly, there are active markets where insurance policies are effectively "traded" like this (reinsurance and retrocession and the Lloyds market). A single policy with sufficient limits absolutely does get syndicated out and bought like this. For smaller policies they get bundled up. But they're professional markets where participants must be regulated because insurance regulation is how we mitigate counterparty credit risk on insurance policies.
But "like insurance" I think was meant as a broader term. Traditional insurance contracts look a bit like options. But forward purchases or sales are also often used as "insurance". The big gain is that purely cash settled contracts (or contracts where cash settlement is possible as a result of sufficient market liquidity existing to allow closing a position before physical settlement) can be used for risk mitigation in other ways which offer much better liquidity and better cost-efficiency in the right markets.
A good real world example is oil price hedging. An airline might want to mitigate the risk that their future cost of jet A-1 goes up. On the other hand, an oil producer might want to mitigate the risk that their future sale price of a particular blend of their crude goes down. Instead of using insurance or entering into bilateral forward contracts, both can trade futures or options on a standardised crude (which neither of them is ever planning to physically deliver or take delivery of[0]). The contract they are trading will not be a perfect hedge for either of them, but it will mitigate their risk significantly. In fact if they are both large enough, bilaterally the liquidity available to them would likely be insufficient to mitigate the same amount of risk.
Having a "single", transparent price also brings some other benefits beyond simple liquidity. For example, it enables several ways to manage counterparty credit risk which would otherwise be unavailable (daily margining, use of central counterparties or clearing, etc).
[0] although the contract might enable an oil producer to make physical delivery of their own blend with a price adjustment
I don't know, but one reason might be history. Modern insurance companies are pretty recent. Before the 1920's, there were mutual-aid societies. Commodities trading is ancient.
But they also do different things:
You need insurance companies for one-off risks. Someone has to go see the house and say, "yep, it burned down." Also, we don't let people bet on other people's houses burning down for good reason.
Other risks are more impersonal, like "what if this company I bought a bond from goes bankrupt" or "what if the price of corn drops in half" or "what if the price of oil doubles." There are lots of people and companies who might want to hedge against those, not just the owner of the property.
Society allows the people to trade futures, but makes it difficult. US brokers seem to make it very easy for “randos” to own equities, but difficult to trade futures. Recently, when I wanted to trade a one-by-one call spread on a commodity future (not saying which) via Interactive Brokers, the required initial margin would have been eight times my maximum possible loss. Bonkers! Hence trade not done.
And what would you rather happen? That you were prohibited?
As others have said, your counterparty won’t know who you are: hedge fund; commercial hedger; rando — unknown.
Provide liquidity. Speculators are trying to make profit, but their existence is important to make sure the farmers are correctly priced.
Do farmers prefer that? Yes, the larger the futures market, the price of selling futures will be closer to optimal. If the market is illiquid, farmers often have to sell futures at a lower prices to market makers.
Many 'randos' like you have lots of money and would happily buy the contract in the hope that they win out, and would be not bummed out completely if they lose, unlike the farmer, for whom such events could be existential.
Whilst arbitrage is certainly something which exists in the financial markets, the vast majority of what's done isn't arbitrage. Arbitrage assumes differing views on valuation of an asset today. So I can buy something from person A, which they believe to be worth value x, and sell it to person B, who believes it to be worth y, where y > x. That's arbitrage in its simplest form - the market has priced something incorrectly, and I can buy it from willing sellers, and sell it to willing buyers at different values at the same time.
The vast majority of financial transactions aren't this - they're speculative. They bank on the idea that money now is worth more than money in the future, and the future value of an asset (using the definition of an asset that it's a sequence of cashflows) is both variable and uncertain. So therefore the promise of future money is inherently tied to the concept of risk. The majority of financial markets trading is based around this concept of risk, and the management of it.
There's vastly more complexity under the hood, but that's roughly speaking, accurate.
Commodities, homes, lands, water, minerals, etc (let’s call them real assets) can not inflated as freely as possible, the way money can be expanded/inflated. That’s the large source of speculation. This is why people borrow in order to acquire real assets.
Third world countries want to issue debt in American dollars, because no one wants to buy their bonds in their home currencies.
Gotcha gotcha, that makes sense, thanks for the clear explanation! So I can see how the arbitrage (thusly defined) has the risk mitigation benefits other people talk about, can the same be said about speculation?
Think about it this way, actors in financial markets all have various beliefs about the future, and all of these beliefs are on a scale of accurate to inaccurate. Speculation allows these beliefs to be aggregated into a single market price (which btw implies no arbitrage) for various types of contingencies and risks, and the price will rapidly update to reflect updates to reality and thus updates to everyone’s beliefs.
Sure. You mitigate risk on speculation by hedging. I'll try and give a similarly simple (if not perfectly accurate and far more lengthy) explanation. Someone mentioned farming financials in the comments around this, so we'll use that. It's also something I know well, as I know a lot of farmers.
Let's imagine that a commercial farmer, whom we'll call Jeremy plants 100 acres of wheat on a farm. Market values for wheat (and everything else you can farm, from livestock to grains and so on) vary and move constantly, as a function of supply and demand. We saw this in an extreme form with the invasion of the Ukraine, and the droughts in Italy last year.
Now the problem with farming is your timescales are long compared to the movements of values for your product in the market, so you've no real idea as to what what you're planting will be worth by the time the bloody thing has actually grown and you've got it harvested and into barns to be sold. And once the seed is in the ground, you can't exactly just plough it all over and plant something else (not strictly accurate, but you don't want to go down that route).
So now let's fast forward. Jeremy now harvests his wheat, and let's say the price has moved up a lot between planting and harvest. Jeremy is a happy man, who's going to have a bumper time, even if his crop doesn't produce as much per acre as he might like at the minute, because it's not raining enough. Or conditions are perfect, and the price has gone up, and he makes a huge amount and can reinvest. Jeremy is a happy camper.
However, if the price falls, Jeremy is not going to be quite so chipper. As such, Jeremy can move his risk, through the use of a hedge. Let's say Jeremy hunts around to find someone to buy his wheat at the start of the season. He might sign a contract with a flour producer, stating that they will promise to buy x tonnes of his grain at £y per tonne. Jeremy now has a fixed price, which has hedged his risk profile. Now his risk has moved from financial to productive - he has to be able to provide the x tonnes. If he can't produce it all on the farm, he needs to source the difference. On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract, but that then gets complex). This is a very good thing, but means if the market prices his wheat vastly higher than he expected, he'll miss out on that upside.
This is called a forward contract. There's other types of contract which can be used to do similar things (futures, derivatives...) but that gets a bit more complex.
> On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract
So basically a third party would step in to assure him that he'd be paid the fixed price for a small fee? Are there no repercussions if the contract isnt honored?
I mean, shit is still going to hit the fan if the contract isn't honoured, but in the simplest terms, yes, he'll still get paid by the insurer if the contract party defaults on the contract. (As a massive scale version of this, see 2007/2008 financial crash. That's basically what happens when counterparties default at scale and insurance contracts have to pay out everywhere, to the level that the insurers themselves have to be rescued.)
Simple example - let's say the contract is for 100 tonnes of wheat at £175 a tonne. So Jeremy should get £17,500 for the wheat he's contracted to deliver. Now let's say that Jeremy has the 100 tonnes ready to go, but the flour merchant can't/won't pay up. Maybe he's in financial troubles, maybe Jeremy ran off with his wife, who knows. But for whatever reason, he refuses to pay.
Now let's also imagine two scenarios - one in which the price of wheat has gone up, and one where it's gone down. In the former, Jeremy is actually happy with this, as he can now sell his grain on the open market for more than the contract, and claim the insurance payout on the contract. On the other hand, if the price went down, Jeremy still has to sell his grain, but he might only get £100 a tonne, which is going to result in a loss of £7,500. At this point Jeremy is very glad of the insurance.
Now the interesting bit is the insurer has the estimate the risk of default, and the likely movement on the market, to be able to offer a sensible insurance product to Jeremy. So Jeremy might pay £1,000 for an insurance product which pays out £10,000 on the default of the purchaser, for example. Obviously the numbers involved here are fictional (apart from the price of wheat per tonne, which is probably around the mark given at the moment), but the principle is accurate.
> Are there no repercussions if the contract isnt honored?
Basically the entire point of futures markets is to standardize the contracts and process by which these contracts are fulfilled to the point where all of that is just part of the pricing mechanism.
Ancient civilizations invented the jubilee (loans should be repaid in 7 years) to prevent speculation on them. But unfortunately, preventing extreme concentration of wealth has fallen out of favour
> Where is the productive output of all these arbitrage shell games? How is this more than an abysmal waste of time and resources simply to make a small handful of bankers richer?
If shares of companies are valued at fair prices it means that the finance departments for that companies can raise more capital. So companies that bring value to society should be able to expand their business.
At the same time, regular people can invest in such companies at somewhat fair prices without doing much analysis. Basically, because the profits above the market average have been taken by smarter investors already. But it’s still good to always be able to put money somewhere and receive avg. market returns.
Yeah, exactly. There is absolutely no way you could have ETFs if the "quick games" were forbidden. Not only because it's the HFTs that essentially run the fund on a day to day basis (see Authorized Participant for details).
One famous example with a completely extinguished price discovery is the Soviet Union. I think this is what killed it more than any internal or international political problems.
> If shares of companies are valued at fair prices it means that the finance departments for that companies can raise more capital.
This only true of companies that were underpriced. Overpriced companies, either because of hype (Pets.com), fraud (Enron) or other reasons (maybe Jim Cramer issued a buy) do not benefit from a fairer price.
>> companies can raise more capital.
> This only true of companies that were underpriced.
You mean over-priced?
because if a company is underpriced, they cannot raise capital as easily, since each share they raise would be underpriced, and thus the existing shareholders actually _lose_ value.
An overpriced company is one where raising capital (via equity offering) is worth doing. If a company was under-priced, it would actually make more sense to do buybacks instead.
I agree with your point, but you misread my statement. We were talking about whether a company would have an easier time raising money once they were correctly priced.
For the reasons you listed, it was hard for the underpriced company to raise capital and too easy for the overpriced company. But those distortions go away once it is fairly priced.
McDonald’s is known to have almost invented and streamlined cooking to industrial level. But McNuggets were made possible only through financial engineering:
Arbitrage and it's various squishier more stochastic cousins are the vehicle by which information flows through markets. Markets exist as a global network of interactions and persistent imbalances anywhere in the system can have massive consequences. Generally, these consequences rhyme with "two counterparties which don't interact with one another directly all that often suddenly discover grave disagreements in the desired price and quantity of something they'd like to trade". Economic wreckage is the result, at least, but also imagine what would happen if corn farmers produced only half the crop that their buyers would have liked to purchase.
So, markets work pretty hard to make sure that information from one area of the global economy can flow to all of the rest of the system with relative efficiency. This works a lot like a game of telephone where changes in one market venue propagate through related instruments to other venues crossing space, species, and even time. Much like telephone, each pair of neighbors wants to do a good job sharing information without loss and, also, over long distances minor errors add up.
Arbitrage is the glue which prevents this from happening. Arbitrage says that any time anyone discovers some level of disconnection occurring, they can make money at very low risk by voting to shift markets to better align with one another.
Arbitrageurs are getting paid to provide a service to the market and subsequently the entire world. Their actions ensure that information flows throughout the global financial system quickly and without relying on centralized planning. Without them, markets could become disconnected and wander out of agreement.
>Arbitrage and it's various squishier more stochastic cousins are the vehicle by which information flows through markets.
>This works a lot like a game of telephone where changes in one market venue propagate through related instruments to other venues crossing space, species, and even time.
Hell yeah I'm not sure where I fall on accepting this way of thinking about things, but the line of poetics/skeuomorphics/analogy is very cool to me.
>Economic wreckage is the result, at least, but also imagine what would happen if corn farmers produced only half the crop that their buyers would have liked to purchase.
This is kind of my sticking point because on direction of that risk is like an actual hazard to my biology and the other is the consequence of allocating food by market. Not saying it's 'wrong' per se, but it does stand out that we're resolving market problems with like market^2
The arbitrage game keeps the prices consistent with each other. It serves to create liquidity so that participants can get their business done without either waiting too long or paying too much.
Ultimately, they are governments, businesses and individuals. All of these actors regularly face situations where they need (or want) to expend money now that they will have eventually but do not have now. The financial markets are primarily about making it as efficient as possible to do that. (There is arguably another side of the financial markets that is about helping people manage risk, though they are somewhat related.)
Most of the financial wizardry you read about in the linked article is related to that aim. It's not always obvious, because a lot of it is higher-order stuff: transactions between financial market participants where payouts are linked to other transactions (or aggregations of transactions) between financial market participants, etc. It can be hard to see the link to the participants I mentioned above. But a lot of it is a means to understanding, and spreading, the risks associated with financing those participants. It is a lot easier to lend people money to finance their wants and needs if you can (a) differentiate between people who will pay you back and people you won't; and (b) share the risk of not being paid back with others.
Not dumb at all. The participants are basically everyone in the market. Everyone buying and selling and speculating on the thing in question.
What they might be waiting on - imagine you have a business wanting to invest in something - new equipment maybe, or opening a new office. That requires capital expenditure. You might not have the free capital to be able to do that. However, if you can improve your cash position, that might be something which becomes available sooner, allowing you to grow more rapidly.
That requires that you're able to secure finance, which means you need someone to either buy something from you now, or to buy the promise of something for the future. In either case, you now have increased cash at bank, which lets you invest to generate returns (hopefully).
This is deeply rooted in the idea that money you have now is worth more than money you may have in the future.
The participants are time-and-space separated buyers and sellers of
- Commodities like wheat, barley, cows, coal, electricity and so on
- Money itself, in which case we call this lending and borrowing
- Money for other money, commonly called currency transaction
- Ownership stakes in companies, aka shares
- Contingent claims like options and futures on the above
Say you want to build a factory to make cars. That's going to cost something, and you want to share the risk with the public.
- When you IPO this company, you get a bunch of money from the buyers of your shares. The owners of the shares, why do they bother? They don't just get all the profits of the company like if they owned a restaurant. They don't control the car factory, they leave that to the management, including how much of the profits are paid out. What if they need the money, despite everyone thinking the company has good prospects? Enter the secondary market, what we normally call the stock market. Here you can find other people who want the shares you don't want, and will give you money today for your shares, even if the company hasn't made a dime yet.
- You have plans with the 10B from the IPO, but not right this day. If there were a money market you could gather some interest until the bill for the factory comes. Some other business needs to make payroll with their receivables a couple of weeks later. You just need to match with them somehow.
- When you start selling cars, you find that a lot of people don't have 50K in cash. Not to worry, you hand these people their cars anyway, and you make a financing plan where they pay for the car with money that they owe you. Now you have a bunch of loans from people, but you can't use the IOUs to expand your factory. What do you do? You find someone to forward you some actual cash on the expectation that the car buyer will eventually give you the money for the car. You just need a market to find this person with the opposite need to you.
- You might sell cars in other countries. If your factory is not in that country, your expenses will be mismatched. If only there was someone out there willing to swap all the Euros you got from selling cars in Europe for your Dollars that you use to pay your workers. It happens that there are other companies in America expanding to Europe needing Euros for their local offices, and having only dollar income. How to find them?
So what happens then? Who is going to match all these different interests? The answer is market makers. Basically people who know that there are clients whose interests match. Your basic middle man who stands there when the farmer comes in, buys the grain, and then waits for the restaurant guy to come in, and sells them. That way they don't need to meet at the same time and place, and they don't need to match exactly.
Not matching exactly brings us to contingent claims. If everyone just transacted everything in the exact right quantities, that would be nice for the market maker. He'd just take a spread on everything and sleep comfortably. But that's not what happens and supply and demand change, and prices change. In fact prices can change a lot, and you might need some sort of deal where you can buy or sell something, but only if the price is at some particular level. Or you might want to buy or sell something definitely, but not right now, only at some time in the future. This whole derivative game allows people to move risks around in order to match their changing balance of buyers and sellers.
I haven't even added speculators yet, but that's the start of a "who/why markets" answer.
EDIT. I know people will ask next. What does any of this very nice sounding imaginary world of completely explicable financial needs have to do with arbitrage?
The answer is liquidity aggregation on similar products, and liquidity spreading by interaction of participants.
Let's say there's a market to borrow money for each year in the future, eg 2024, 2025, 2026, and so on. Some guy decides he needs to borrow money for 2025 to build a factory. As a market maker, that's fine, but hey wait a minute. There's nobody I know who wants to lend in 2025. What do I do? I have this guy who wants to lend in 2024 and a guy who wants to lend in 2026. Hey, maybe I can just do all these deals, paying me a spread? My books will be slightly off balance, but don't interest rates basically move up and down together? Let's do it and deal with the mismatch later. So now these related markets are connected. They are sort of one large pool of liquidity, but still their own separate pools since there is still some difference.
This is a loose arbitrage. You're not guaranteed to make money on it, since rates can move the wrong way for you. But this is also the most common arbitrage, the one where you sort-of hedge your book against similar things and hope the imbalance falls out eventually.
The thing that I’ve always found wild is that the money people make on markets seems to be so much higher than the money people who actually make goods/services.
Why has the global economy put such a high benefit from investment bankers compared to, for example, family doctors?
they can only scale at most linearly, with the number of hours they work.
A financier can scale multiplicatively, because the amount of the monies they deal with can increase without "extra work". The multiplicative nature means the more capital you have access to, the more money you get to make, which approaches exponential at some point.
And in the end, the financier speculating on the markets can affect many more people than the doctor ever can in their life.
For one, finance is a macro force multiplier; it can make or break entire other industries. There’s also a bit of selection (global top) and survivorship (plenty of less visible non-success stories) in the wild money stories you can see out there.
E.g. interest rate risk. Maybe I've sold a bunch of variable-rate bonds before. But now I am worried about interest rates rising. I can't call the bond for some reason (maybe not enough money, maybe some regulatory reason). So I buy an interest rate swap that pays out if interest rates rise.
This isn't false but it feels reductive. A financial instrument that allows one to bet on the corn harvest is obviously valuable to the corn farmer, as it allows them to use profits from good seasons to hedge against bad seasons. They're also valuable to people whose business is affected by the corn harvest - cereal manufacturers, say. The problem is that they can also be used by people with no exposure at all who simply want to bet on the corn harvest, and from the scale of the finance sector it seems like we are pouring a lot more of our resources and brainpower in to designing exotic new ways to bet on the corn harvest than we are on growing corn.
> as it allows them to use profits from good seasons to hedge against bad seasons
It allows corn farmers to grow wheat instead, because he is selling it right now and wheat is more profitable right now.
The main reason why it doesn't go astray and make people hungry is because people that isn't involved in any way can go, study the factors that make wheat more profitable to corn, do their predictions of what will be the case at the point of delivery, and if they predict correctly that the price is wrong they can go and adjust it making a lot of money on the process.
I'm not sure how this is related to my post so perhaps I was unclear. I'm not talking about individual corn farmers and the choices they make, I'm talking about how we as a society and an economy allocate our resources. I'm saying that derivative financial instruments have value, for the reasons I suggested and the others described by sibling commenters, but that the finance sector is larger than that value warrants.
I'm not sure why I'm being downvoted, as I didn't think this is all that controversial. Historically, finance was a much more boring and less lucrative field than it is now, and consequently much smaller. "I'm a super smart 18 year old and I want to get rich, so obviously I should go into banking" is a relatively recent phenomenon. I agree with everyone else here that the industry has value, so presumably its recent explosion in size has brought some additional value, but it's very hard to believe that value is large enough to offset the opportunity cost of a generation of ambitious geniuses not going in to science or industry or becoming entrepreneurs.
The buyers and sellers of a futures contract are both trying to offload risk onto someone else. The risk profiles of both sides don’t always offset exactly, so speculators are necessary for functioning commodity futures markets (and markets in general). Also, price discovery is much more efficient with more liquidity, which is what speculators provide, in addition to risk assumption.
Sure, I get this and agree, but price discovery and facilitating markets are subject to diminishing returns just like anything else, right? I don't think I would've been downvoted for saying something like, "It's a problem that it's more lucrative to speculate on existing housing than to build new housing, so we should make regulatory changes to address that" and this feels analogous to me.
Commodities are fungible by definition and used in the production of all sorts of things. More commodities are constantly being grown/mined/pumped and sold onto the market.
More housing is being built, but housing is not fungible, nor is it used as an input for manufacturing. I’m not sure what you’re trying to imply by saying if you were making a completely different argument about housing speculation being bad, the reaction would be different. Of course it would, it’s a totally separate argument from the one we are having about commodity futures.
I’m not sure why you care so much about financial speculation, it provides more accurate pricing and lowers transaction costs for the actual users of the futures contracts who take delivery of the commodity.
In my opinion, your arguments are coming from an emotional place. Try and examine futures markets from a place where you aren’t thinking about greedy rich Wall Street guys, the amount of money they make is irrelevant to futures markets being useful tools for producers and consumers of commodities.
> financial speculation ... provides more accurate pricing and lowers transaction costs for the actual users of the futures contracts who take delivery of the commodity.
I understand and agree, as I've said pretty explicitly in both of the comments you responded to. I'm arguing that the finance sector should ideally be smaller than it is, but you're responding as if I said it should disappear entirely.
> In my opinion, your arguments are coming from an emotional place. Try and examine futures markets from a place where you aren’t thinking about greedy rich Wall Street guys, the amount of money they make is irrelevant to futures markets being useful tools for producers and consumers of commodities.
I don't have any an animus against speculators; please try to read more charitably. The rapid growth of the finance industry over the last two generations is a result of the policies we've enacted, and the position that it should be smaller is an argument for different policies. Similarly, "it seems like we are pouring [too much] of our resources and brainpower in to designing exotic new ways to bet on the corn harvest" is a complaint about the system that incentivizes that outcome and the policies that produced it, not about the individuals acting within that system.
> I’m not sure what you’re trying to imply...
I wasn't suggesting that commodities are similar to housing in any way; I was saying that, since a lot of people seem to recognize the societal cost of speculation on housing specifically, that I was surprised to be downvoted for complaining about the cost of speculation more generally (which, I remind you again, is not the same as saying it shouldn't exist, only that our economy ought ideally to produce less of it).
The output (generally speaking, not specific to money markets) is better prices. There are large scale examples of economies in which prices were mismanaged either due to lack of information/technology or centrally planned prices, some of which resulted in failed states (e.g. Venezuela and the Soviet Union). While providing market information signals via prices is certainly an abstract concept that most people will never appreciate, it is important regardless.
For complex instruments in money markets, the main effects are bridging mis-priced treasuries on different time frames and hedging against various outcomes for pensions, banks, and dealers in physical commodities.
Most of the complex stuff either serves one of those purposes or becomes a zero sum game that doesn't affect non-participants. It's important to judge each instrument by its purpose and mechanism rather than bunch everything as a way to make bankers richer (e.g. a future vs. a CDO).
> lack of information/technology or centrally planned prices, some of which resulted in failed states (e.g. Venezuela and the Soviet Union)
Venezuela has never had Soviet-style central planning. It's a market economy with a public sector only slightly larger than the OECD average. Their current situation is largely the result of excess social spending: first at the expense of investment and diversification away from oil prices were high, then at the expense of currency stability when oil prices crashed.
While you're correct that high social spending that relied on high oil revenue was probably the primary cause of Venezuela's economic collapse, they had price controls on food starting back in 2003 and they began nationalizing major industries in addition to oil by 2008. From 2008, it was a full on centrally planned disaster.
Ownership and allocation mechanism are mostly independent axes. Consider for instance Norway (extensive state ownership but highly market-oriented; in certain respects more liberal than the US) contemporary China (state control of most major firms but mostly market-oriented), Gaullist France (nationalized infrastructure plus minority state shares in other sectors, markets supplemented with indicative planning and state-directed investment) or the US during WWII (almost entirely private, full-blown central planning).
Venezuela's level of interventionism is unremarkable by the historical standards of the developed world. The problem is their poor choice of interventions.
why would this be surprising? Don't believe for a second that the USA has a generally more liberal financial market than Scandinavia. Employment laws, trade, regulations, etc. are often wayyy less strict in Scandinavia.
It shouldn't be surprising, but American political discourse has unfortunately latched onto an extremely simplistic univariate model of economic policy. There's a common background assumption that redistribution, public ownership, fiscal policy, and all varieties of regulation rise or fall together.
Futures and options were born from commercial needs.
Suppose you produce oranges. It'll take a few months for the harvest, and while costs are generally well understood and stable, at what price will you sell those oranges? What if by then the price of oranges tanks and you find out you're not turning a profit? This is where futures come in. The producer can sell a number of futures contract to lock in a future selling price, making cash flows much clearer and predictable.
Conversely, there's the case of a factory that needs to buy oranges for its products. They have the opposite problem and would like to make costs more predictable. Then they'd buy futures to lock in a future buying price.
> How is this more than an abysmal waste of time and resources simply to make a small handful of bankers richer?
Interesting observation given that your own wealth is managed this way.
Whether its the simple bank deposit in a checking account, if you've ever chased an interest rate for a savings account, or had your earnings managed in a retirement account from your employer, or if you attempted to make money faster because a debt was coming due.
Its all tied together and a product of this system.
The goal is to keep money moving within the economy, as people also race to hoard it.
Generally speaking you can group large financial institutions into two groups: sell side and buy side. I’m no expert, but afaik, these firms either SELL liquidity (e.g. investment banks, market makers etc.) or BUY liquidity (for example pension funds, certain hedge funds). Liquidity is the key here - that is (if any) the benefit they bring to society. I can buy/sell pretty much any financial product/risk with reasonable spreads because there’s always someone on the other side of the trade ready to be my counterparty.
Not that I want to defend some of these institutions, though some are better than others, but it’s important to keep in mind that they do take on risk in order to provide us liquidity, and most of them specialize in managing the risk, some of them are even good at it. Their infrastructure and connectivity and the price they charge you to provide liquidity allows them to make profits, but they do lose money sometimes. Also, compared to 20 years ago, there’s fierce competition now in pretty much every aaset class - if you work in one of the buy/sell side firms, you’ll very often hear terms such as spread compression etc (except the Covid years of course - people just wanted to trade, nobody cared about the price of liquidity (e.g. spreads or sales credit etc.) they had to pay)
Not sure if you meant “money market” as it’s understood to be the market lending/borrowing for terms of less than a year, or if you were referring to fixed income markets in general.
Either way it’s hardly a waste of time or money, and banks make money not from “arbitrage shell games” but by matching buyers with sellers. Some people have money to lend and sone people have enterprises they need to fund.
While there are casinos, think: A farmer wants to get a fixed price for next years crop and insure against a bad harvest. Thats why you need these things.
Ok the farmer example is a trope apparently. Any business where you need to hedge financial risk. Lending too many mortgages to self employed people? Sell that risk / revenue stream on to someone else and buy something different to diversify.
Others have provided excellent answers. There's one thing I'd like to add. In order for the financial markets to provide more utility, a financial transaction tax needs to be introduced. It will indirectly kill unproductive or counterproductive financial activity such as high frequency trading.
Sibling comments have provided good explanations of why modern economies need finance: risk management, capital allocation, enabling ventures, and so forth.
At the same time, it’s worth asking the question of why the financial sector just keeps growing and whether that’s desirable. Shouldn’t improved efficiency with digital systems make this intermediation layer thinner, less labor-intensive, more competitive? Instead it seems to be capturing an ever larger share of the economy’s output to itself.
In my opinion regulators should try deploying some blunt tools like transaction taxes and hard salary caps, and see if we’d be any worse off with a smaller and poorer financial sector.
One example which is applicable to majority of the working population: in the UK at least the fixed-rate mortgages are priced off the Swap rates as that is how banks hedge them.
The value add is offering financial products that consumers want.
Businesses and people need to loan or borrow money, offering a wide variety of products that suit different needs supports economic growth.
A good example of this are all the foreign companies that decide to go public on the NASDAQ. They aren't doing it in their home country because of a weak (or non-existant) equities market, or burdensome regulation.
When it results in a concentration of wealth in the hands of people who can abuse it for political ends, or results in market crashes that cause knock-on impact to real humans - then yes, worrying about it is reasonable and justified.
Belittling people pointing out selfishness as merely being jealous is not the slam-dunk you believe it to be. And, as diordiderot points out, I'm not trying to _take_ anything from anyone, but rather pointing out that they way they accrue more wealth (and power, with which to continue to accrue more...) is dishonest, arises from inequity, and is a net-negative to society.
> if you follow the “force is only justified in response to force” principle
Feel free to not trade in this market then. “Mom they won’t share” is also not a particularly convincing way to justify the right to other people’s money.
Why is it their money? Your're starting at the wrong point in time friend.
You need mommy just as much.
E.g. Chad Ungabunga sees alphanumeric living on fertile soil with an attractive woman so he's going to bonk him over the head with a club and take his stuff because he's bigger and stronger.
It’s their money if you follow the “force is only justified in response to force” principle. They didn’t obtain their money by force, so you can’t take it by force from them.
I believe that principle should be enforced by the government, that’s the only thing I need mommy for. Given that you also believe in police, military and courts, on top of a bunch of other shit (like stopping consenting individuals from trading their own money), no I don’t need mommy “just as much”.
I'm with you, but I apply the same logic to all rent-seekers and shareholders. We'd be a lot better off if we didn't have parasites and bottomless pits embedded in the economy by design.
Same with the majority of tech companies. All you do is endless meetings, plannings, reviews and extremely little actual human brain is used for productive output.
Quite. The general response I get from questions like this to financial folks is that these markets and vehicles and products are important "for liquidity", but they can never quite tell me who liquidity benefits other than the system itself.
If you own equities (individual stocks, ETFs, mutual funds) then you benefit. More liquidity means lower bid/ask spreads which means lower transaction costs and higher returns (since you are paying lower transaction costs, more of your money is invested and it adds up over time) for every investor. The NYSE minimum tick size used to be 12.5 cents, then 6.25 cents.
Once HFT firms started becoming more widespread, the spread lowered significantly. SPY bid/ask spreads are 1 cent on a share that costs ~$450. Some assets even have sub-penny bid/ask spreads.
The traders that create units of SPY get better spreads on the underlying stocks too, which benefits you as well by reducing asset fees and more accurately representing the NAV by lowering transaction costs. The S&P 500 is made up of 500 stocks, it is much more cost effective to assemble a basket of stocks with 1 cent spreads than 6.25 or 12.5 cent spreads.
Liquidity does the same thing for every market, it increases the speed and accuracy of price discovery and lowers transaction costs.
> If you own equities (individual stocks, ETFs, mutual funds) then you benefit.
Right, yes - I as a relatively-wealthy individual certainly benefit from an effective market. But does _society_ benefit from the existence of a stock market in the first place? Does the increase in wealth for those at the top outweigh the comparative-loss (stagnation relative to inflation) to those who can't afford to buy-in? I find it hard to morally support a system whose justification boils down to "it redistributes wealth to the wealthier without providing any net-increase in quality of life".
It benefits people who need to raise cash, because they can do it more quickly and generally with lower financing costs than in an illiquid market.
It benefits people who have cash that they want to invest, because they have more opportunities to do it and more visibility over which investments are safe and which ones are risky.
Therefore it benefits society by transferring cash from people who have it now but need it later, to people who will have it later but need it now. Enabling and facilitating actual socially good activity, like manufacturing goods, providing services, etc.
So there are definitely benefits to people outside the finance industry. However, in order to accept any of that you do ultimately need to believe, to some extent, in the market as a means of allocating resources. You don't need to think it's perfect, or that it shouldn't be regulated, or even that it is the fairest system, but you need to accept that it is the system we use. In a totally state-planned economy, finance wouldn't work or even make sense.
Interesting - I'll definitely have to think on that one, thank you! I suppose another required assumption (implied but not explicitly stated) is that the activities undertaken by "people who need to raise cash" are, on balance, good things for actual people. Despite the fact that we overwhelmingly hear about the negative examples, I guess this is _probably_ true? Ugh, I suppose so.
I wonder if there's a way to derive those same benefits (people doing useful work have access to funds) without the exploitable loopholes (sufficiently clever and evil people can shuffle numbers around and fabricate wealth without _actually_ affecting loan-availability)? I suspect that's probably a provable invariant - you can't have one without the other. Shame.
All these Financial guides are very interesting. But beware of falling into the illusion of being a good-enough active investor. It's like entering the Pro league as an overconfident amateur. The other players are the best in the universe. And they have cybernetic extensions: algorithmic trading with virtually limitless amounts of resources and information. And sometimes they have "alpha" you'll never, ever get your hands on. They prey on "dumb money" like naive/retail investors and pension/mutual funds.
And at these times of high rates and inflation, the only safe move seems to be money market accounts and take the delta inflation hit. Try to focus your time in more valuable things like your friends and family. And keeping your sources of income.
Agreed, strongly. Which is why the online edition has some “Cautionary words”:
> Pricing Money is a beginner’s guide: it says so in big letters on the front cover. I believe it to be an excellent beginner’s guide — presumably many authors believe their own books to be excellent — but, being a beginner’s guide, it will not immediately make you a world-renowned expert.
> It was written around the turn of the pedant’s millennium. In some parts it shows its age. It has been slightly freshened by the addition of green-boxed updates, but these have been written very concisely, more to point to developments than to explain them fully.
> Please do learn from and be informed by Pricing Money. But also be cautious: it is not enough to make you a world-renowned expert; it does not list the many details that are both dull and necessary; some things have changed since it was written; it cannot be your risk manager.
I’m not going to argue that asset managers and trading desks have plenty of resources and that they can transact very quickly and cheaply. But having been on the inside of small and large asset managers for almost ten years, I can say there’s a lot of groupthink and rather brain dead behaviour to be seen on a trading floor.
Call me jaded but I’ve worked with both systematic and discretionary traders. The algos I’ve seen tend to be heavily overfit, and stop working as soon as they hit production. The discretionary traders usually have a tonne of gambler’s tics and have a bad habit of assigning narratives to market noise.
Most institutional traders aren’t the best in the universe. They just do dumb things faster and at bigger scale than day traders.
Indeed, institutional traders and asset managers are still the "buy side" and as such are not crazily more informed than retail.
The real sharks are on the sell side, using low-latency arbitrage and massive leverage, and have the ability to unwind risky positions over months. Fleecing buy side and retail is highly profitable for them.
In their defense of course they'll say they're "providing liquidity", and given how much buy side tends to pile up on one side of the trade, you can see their point: somebody's going to take the other side of these big moves.
Agree that people should not do active investing, although the solution would be passive investing (index funds), which allow you to focus on friends & family without missing out of the economy's long term gains.
Hot take but I'll bite, what's your rationale? We're only ~9% down from VTI's ATH and what happens now doesn't matter when your investing horizon is 15+ years.
This is terrible advice BTW. I got it in 2007, also HN and FT forums convinced me. So I put significant savings in a couple of index funds. I lost 40% within months. Left it there and recovered only after 8 years (and that's not even adjusting for inflation or MM rate). Please be a bit more self-aware. I spent many years in finance and the more I learned, the more I realized how much I don't know.
If you're investing a chunk of every paycheck, you'll keep plowing money into the index fund through every dip, which historically makes up for the money you add at peaks. You can spend a few years derisking as you approach retirement, which is similarly not that susceptible to recessions.
I meant to put money in index funds right now. Not ongoing investment over a long time.
And going back further to my original point, if I had money in funds now I'd move it to Money Market accounts because the risk of a stock market downturn is big (1987/2001/2008 style). You are not Soros/Buffett/Munger or a multi-billion dollar hedge fund.
- Recession now undeniably starting (several friends in Tech are losing their jobs in companies doing well)
- Ballooning deficits and debt at every level
- High rates making debt ballooning faster
- USD dominance decreasing
That's known and now not matter of opinion but hard facts. Now, where to invest? I have no idea (and I'm pretty sure traditional investment knowledge doesn't work anymore), so I do money markets and take the hit until I figure something out. Maybe there's a non-hype AI application opportunity somewhere, who knows. Worrying too much makes you do dumb life-altering things. In uncertain times, I chose to invest the time in enjoying life a bit. Wait and see.
Core inflation is going down, just not as fast as other sectors. People losing their jobs is not a hard fact of a recession, we have one of the lowest unemployment rates in history.
I'm just indexing and staying happy, worry free, it worked for the last 100 years and I'm sure it'll work for my lifetime.
I have a similar outlook. If the stock market starts losing against inflation over my time horizon (several decades) then we have bigger problems. There will be recessions in the future. I'll keep tossing money into index funds through the bottoms and enjoy coming out the other side. Every three months, I get a statement in the mail telling me how much money I've made or lost. That's all the attention I need to pay to my longterm finances.
i feel that this assumes the large investors on wall.street are playing the same game as retail investors. Given the size and scale of their accounts, I'd imagine it's an entirely different playbook.
My (limited, retail only) experience tells my gut that most retail investors do it to get rich, and not to learn the markets, learn the risks, and build a business. They are different goals, granted both do seek to make long term gains.
I like to believe that retail investors can make it if they put in the effort and learn to manage risk appropriately. At least I need to tell myself that as I work towards making money in the markets myself.
I am definitely dumb money right now, and I could also be delusional, but saying there is no hope so give up and just do something else completely is just defeatist.
Surely it must be possible to learn how to do whatever these so called "smart money" types are doing. Or at the very least learn how they operate so we can identify and avoid their attempts at predation.
I read a couple of pages and it looks good. I’m not a complete beginner but it’s still filling in some gaps in my knowledge. I appreciate the author’s work and giving it away for free.
That said I feel like it’s skipping some explanation for what’s supposed to be a beginner’s guide. One thing that sticks out to me is that it jumps straight into talking about interest rates without explaining the time value of money and why interest exists.
I wanted a book I could recommend and to others who knew even less than me, but I don’t think this could be it.
(And maybe interest is covered later on, but the ordering is important)
This is really interesting. Very early in my career I worked on a team that supported the interest rate swaps desk at a large investment bank. Not one person told me to read this book. I still don't know what they are. Wish I read this back then!
I am always amazed by Finance. But the engineer in me somehow always failed to grapple after few trenches deep into the realm of terminologies. I am strongly considering the MITx Finance specialization, but this resource is a great stop gap.
Growth doesn't require more resources. If your barber finds a way to cut your hair 10% faster, that shows up in GDP growth. Increasing efficiency leads to increased GDP.
Yes, of course. The quantity and quality of the output can certainly grow for a given resource input -- obviously with physical limits but we haven't generally reached those. It's possible to breed higher-yielding crops, design more efficient industrial processes, to craft with less waste, etc, and these have all been vastly improved over the past few centuries.
The problem is that these industries have also been growing by increasing resource consumption along with output, to a level that isn't sustainable (even without more growth) beyond this century or so.
You must think in terms of ratios, or not think at all. Debt-to-GDP ratio is a good measure that takes into an account most other variables like changes in population, productivity etc.
Question about the "Yields of Australian Commonwealth government bonds as of 21 January 2000" graph in Chapter 2 (page 13 of the A4 version):
The y-axis (Yield in percent) values don't seem to match the data points. For example, the point for Feb '01 is labelled '7%' but the point is just above the 6% mark and well below the 6.5%. What am I not understanding?
Coupon is the bond’s interest rate, per 100 nominal. Yield is the effective return on the money per 100 cash paid, so allowing for price. Coupon ≢ Yield.
One bit of feedback is that it seems quite difficult to read on a phone with small font requiring zooming and then horizontal scrolling. Both the website and the PDFs.
Being so text heavy I imagine it should be fairly easy to add some CSS to make it more readable.
I am interested in this, but already confused on page 1. The book describes a bank needing to borrow swiss francs, but that doesn't make sense to me. Why not just borrow the money in their native currency? Does the book ever go into this?
If you borrow in a different currency than your assets then you introduce currency risk. For example, if I make a loan of 100 CAD by borrowing 100 USD, then when the loan finishes I might only be able to convert 100 CAD to 50 USD.
If you download the html of the page, you can put it into Calibre and use Calibre's convert feature to generate an epub. I have not tried putting the generated file on my e-reader but it looks fine on desktop.
Caution: the PDF is a bit behind the HTML. My fault. In particular, the (excellent) chart on the recent crash in fixed0-income price is not in the PDF.
This looks like an amazing resource. The problem I have is digesting all the information and financial/mathematical data. I tend to get overwhelmed by densely rich books and sort of tune out as I read.
On a related note: does anyone have good recommendations for printing services that can print and bind an online PDF, etc? I've looked into lulu.com and printme1.com but haven't used either for this purpose.
I've wanted to do something similar for some of Beej's guides that are not in regular print, and would definitely consider for this too.
I looked at lulu for printing Scott Alexander's Unsong. Their terms of service declaim [0] anyone looking to print content that they do not have copyright or a license for. That's the entire point of copyright.
Most local printing places (places that do business cards, flyers, and the like) will gladly supply a quote for a single printed and bound PDF. Last time I did this only had to send the PDF for a complex flight sim. Shop local!
I had a college course use Lulu to print the notes into a textbook. The quality was good for a paperback. I think you're limited to black and white though. The formatting of the TeX notes could have been better, but that's probably on the professor to have fixed.
While stocks last, hard copies of Pricing Money can still be purchased from Wiley, Waterstones, Amazon.co.uk, Amazon.com, Amazon.fr, Amazon.de, Amazon.co.jp, Abe books, as well as other bookshops: cite ISBN 0‑471‑48700‑7
I commented it elsewhere with the correct link (but it's good enough to deserve its own post so here it is but I posted the link on my phone so something got borked)
