Nathan Scandella (personal)

TMI (Too Much Information)

Warren Buffett called them "financial weapons of mass destruction". George Soros says Credit Default Swaps (CDS) should not be traded at all. Most of the financial sector, however, will attest to the benefit of the various types of derivative instruments we allow our financiers to buy and sell. Any attempt to ban certain instruments, or limit their spread, is greated with the following argument:

Taking away XYZ in the market will remove liquidity and valuable pricing information, and make markets less efficient.

You replace "XYZ" with whatever you like. Their answer is always the same. Here's why they're wrong:

First of all, let's clarify what they mean by "efficient". Efficient does not mean that they do more with less, which is sort of the Engineering definition of the term. If finance was ever efficient in those terms, we wouldn't have seen the financial sector swell to 25% of the S&P500 market cap a couple years ago, accounting for 40% of corporate profits, while they led us off a cliff. In financial markets, efficiency refers to market prices accurately reflecting relevant information. Market pricing does some of this, but it also builds in the speculative trends, the human emotions of exuberance and panic, and all sorts of other non-fundamental factors. Soros refers to this as "reflexivity", meaning that markets are not efficient, but rather reflect the biases of the participants in a way that makes bubbles, and panics self-reinforcing for short periods of time, and prices in general a dynamically varying function of human emotions. This portion of a market price is very difficult to separate from the asset's fundamental value. If all the derivatives market gives us is a price, who can sort out the hard economics vs. the fads?

Second of all, regarding liquidity. It is true that under the status quo, the high-frequency trading of securities, and their derivatives, provides liquidity that benefits the "slow money" players in the market (that's the rest of us). However, what isn't true is that if a particularly dangerous instrument (CDS comes to mind) were removed from the marketplace, all else would be held equal, and we'd be left with a liquidity crunch. CDS is a particularly easy example to use, because they haven't been around very long. As recently as 15 years ago, we were able to get by without CDS, and had enjoyed several decades of economic expansion. And the first few of those decades were real, not merely fabricated out of massive debt run-ups.

The opportunity always exists to do something else with your money. Without CDS, for example, AIG's Financial Products group would have found something else to invest in. Heaven forbid, that might have actually been real insurance products! Many people don't realize what a small portion of the total liquid assets in our system the stock market represents.. Were institutional investors to have fewer choices, more of them might wind up in the markets that the rest of us invest in. With greater market depth (not just notional value, but with more participants), we might see more stability or "efficiency" in equity pricing. All you need to do is watch the last few months to see what a stock market with liquidity withdrawn can do in terms of wild, often irrational, price fluctuations.

In a well-designed economy, we would also have control of the money supply handled by a centralized entity. Many believe that to be the function of the Fed, in the US, but the Central Bank is currently a very poor implementation of centralized monetary control. Just watch what Ben Bernanke is currently trying to do, and what the financial markets are actually doing, to know that the Fed can nudge the market in the direction it wants, but it can't increase the money supply when lenders don't trust borrowers, and borrowers are scared to take risks. Were the Fed, or another hypothetical centralized entity, to be properly designed, we would not be so concerned about losing liquidity due to the loss of a particular financial instrument. The monetary authorities could compensate for such a loss by promoting liquidity in other ways. In our system, we have delegated the responsibility of money creation to a loose collection of private bankers, who are about as easy to herd as cats. Fix that problem, and your options for controlling derivatives look better.

Finally, regarding information. If you couch the argument in terms of "more information is generally better", then I'd agree with that point. But, that doesn't mean that all information is good information. I don't think the show American Idol would get better by letting the contestants' mothers sit in on the judges' panel. Similarly, all financial information is not of equal value. I think the global economy is now big enough, with enough information exchange, that we have sufficient numbers of opinions about what the price of XYZ should be. What we need is more insightful information. This is what the financial media should be providing, but don't. Instead, we have CNBC, and clowns like this guy:

We have got a whole industry of smart people making lots of money simply pushing paper from gullible client A to uninformed investor B, hoping to skim a little profit off every transaction. What we don't have is enough talent on the government and media sides of the financial sector, to ensure that consumers get something for their money. It would be wonderful if we could simply encourage everyone to act in their own self-interest, and the greedy derivatives trader would actually benefit society by correcting the price of the underlying security they dealt in. But, finance isn't so simple as to be able to boil all useful information down to a dollar sign, and two little numbers separated by a decimal point. A picture may be worth 1000 words, but a price alone is not enough to steer us clear of financial collapse.

When a parent raises a child, the child invariably gets to a stage where they choose to express themselves in unproductive ways. My favorite was throwing ice cream at my parents' walls. The phrase that's currently popular for handling this response is "Use your words". Let's apply this to derivatives traders. If you really think you're providing a service to the market via your analysis, and subsequent pricing bids, you need to go a few steps further and use your words. Precious few honest words were thrown around before the global financial crisis. Even less hard analysis. If traders can spend 14 hours a day sitting in front of 4 LCD monitors drawing slopes on high-frequency pricing charts, they can spend the time to find out that banks are lending money to anyone who can fog a mirror. And then they can write about it. With words. That's the kind of information we need.

Posted at 03:45AM Jun 13, 2009 by Nathan in Economics  |  Comments[1]