Exponential finance

A talk by the futurist Ray Kurzweil was recently played on the ABC in which he talked about the accelerating rate of innovation when it becomes part of what is broadly termed the information technology industry. He argues that in the future medicine, biology, economy and social relationships will be subject to information technology and the law of exponential return. His contention is that whereas in other sectors innovation tends to be advance in a linear fashion, information technology behaves quite differently. For instance, he predicted that the human genome project would succeed within the desired time frame. When it was halfway through and only 1% of the genome had been mapped, he was told that he was going to be proved wrong. He replied that on the contrary it was right on track, exactly in line with the exponential growth curve. It came in one year ahead of schedule. Using the same logic, he says, solar power will dominate world energy supply in about 16 years. Medicine will be transformed in about the same time frame. We have already seen the phenomena in areas like the internet and social media.

My first thought listening to it is how difficult it makes investment, because it simultaneously creates great uncertainty in industry structures — see, for example, how social media has changed conventional media, or file sharing has changed the conventional music industry — while making timing excruciatingly important. It is not enough just to pick the new sectors, on exponential curves investment timing has to be just right. For most of us, it will be wrong. The dot.com boom is a case in point in going too early.

My second thought is that this exponential IT curve has already hit finance, and it explains an awful lot of the problems now being witnessed. The explosion of derivatives, now a startling $700 trillion, well over half the capital stock of the world, has been driven by IT geeks and rocket scientists. The explosion of high frequency trading, which is similarly startling, is also a geek domain. Finance is no longer a discrete industry, it is now part of the IT juggernaut. And it is not going back.

This creates, in my view, far more problems than it solves. In fact, it is downright dangerous, because it leads to self referring, feedback loops that do not occur in other industries. If the energy industry starts to become an IT industry, as Kurzweil predicts is occurring with solar power, then the outcome will be more energy capacity at a lower cost. If the medical industry becomes an IT industry, then the outcome will be much cheaper and new medical treatments. The music industry has been transformed by IT, reducing the cost of recorded music to levels that are negligible, and, in many cases, removing the cost completely.

Now how are these innovations measured, in terms of their impact? By price, or the amount of money required to get a certain outcome.  So if the same thing occurs in the financial system, which it has, then how do we measure its effects? We measure the change in the volume and range of monetary instruments by price, or an amount of money. In other words, we measure it by itself. And because something cannot be measured by itself, then we have lost the most important role of money — its function as a store of value. To measure the value of something effectively, by definition you have to have something else with which to measure it. You cannot measure the value of something with itself. Grab your shoelaces as hard as you like and you will still not be able to lift yourself off the ground.

Such self referentiality is, I suppose, a characteristic of the post-modern, post industrial world. But no one is in any doubt about how dangerous financial “innovation” is to the architecture of the global economy. Innovation is entirely different in the finance sector to other industry sectors (I am even sceptical about calling finance an industry, although I suppose it is). Innovation in this area results in tampering with the rules on which everything depends, money being in the first instance rules about value and obligation. In 2008, we saw what that means.

The IT revolution cannot be unwound; finance is now an IT industry. But it MUST be seen as a special case, requiring much more intense governance and sensible thinking about risk control, as opposed to the circularities of models like value at risk, or the Ayn Rand inspired nonsense prosecuted by Greenspan, in which pure self interest was always and in every case beneficial. More specifically, you have to measure the effect of monetary innovation with something other than money. That means looking at things outside money, such as, perish the thought, morality, or, if that is all too hard, at least social utility.

Comments

  1. I can understand music, finance and maybe medicine, but you cant call solar energy an “IT industry”. The power still needs to be converted from solar energy to electrical energy, and this is very infrastructure intensive.

  2. derivatives problems, assuming it is a problem which is a separate debate, can be fixed by requiring participants to have an interest in the underlying — equivalent of an insurable interest in the insurance industry.

    As for exponential growth, I am still waiting for people to note that (western parliamentary) democracy seems to necessitate an exponential growth in legislation, which cannot continue indefinitely — unless you expect the entire population to be employed in government of course. As some point in the future the schlerotic nature of western parliamentary democracy will have to give way to some sort of alternative …not sure what that will be though.

  3. You can try to control it all you want, but the trader bots are out there and no bank is going to give that up. Australian banks are laggards in this matter, for sure – the fact that we still pursue an overnight settlement strategy for inter-bank transfers shows me how under developed this market is still.

  4. There is an obvious reason that finance has been so readily colonized by IT, and that is that financial products are almost purely abstract artifacts. Since it easy to describe, measure, see through and condense the abstract in purely mathematical terms, it is relatively simple to apply IT to the processes of designing, creating, storing, distributing, exchanging and re-cycling or extinguishing financial products.

    And this brings me to a second point, which is that while finance is as much about the creation of products and/or services as any other industry, it is almost more easily understood by comparing it with physics than, say, making ice-cream.

    The output of financial production can have a life-span of only a few seconds (in algo-trading) or many decades (US Treasuries); financial products are interchangeable and mutable, even reversible. Their very immateriality allows financial products to serve as substitutes for – or hedges against – each other as well as against the always-oscillating processes of the natural, material world. (There is a dull but good sense in which having a mortgage and a housing loan is buying a hedge against the cold…)

    Financial artifacts can not only be used to “re-construe” the physical world, they also introduce time into resource allocation – production, consumption and stock-piling. That is, finance allows these physical events to be conceived of and manged as “processes” that can be observed and managed. Finance and IT provides the structure and the means for measuring, compiling, calibrating, comparing and exchanging or substituting all manner of finite objects or values across time and space.

    This being so, the deployment of information technologies and the techniques of financialization could lead to accelerating rates of innovation generally. That would be a very good thing, because we certainly need to learn to do more with what we have – to improve our whole-of-system productivity.

    • Financial systems can be viewed as signalling and control systems for real economies. IT by its very nature is particularly well suited for applications in control systems so to be precise finance is not IT but an area of its application. Unfortunately due to their flexibility, complexity and operational speed IT systems facilitate a lot of harmful ideas such as HFT whose only purpose is skimming money rather than benefiting from supporting the underlying real economy so in effect HFT is more of a virus rather then a proper financial mechanism. Unfortunately it seems that the only way of preventing abuses is by regulating financial markets which will probably be an ongoing process of reacting to new dangerous phenomena.

      • HFT is widely criticized. However, since it probably cannot be outlawed, and will come to totally equity markets, it won’t be long before the investment instruments offered to long-term/retail investors will be access to the trading incomes of the HFT platforms themselves.

        Considering the ease-of-start-up, it is is surprising this has not already become widespread. This is the next step…on the principle that if you can’t beat em, join em.

      • HFT is not a virus or valueless, HFT is a method of finding valuable information and getting paid by the marketplace for improving prices or liquidity. Vanguard, one of the world’s largest money managers, has made statements that a retirement account, at cash out, will be worth about 40% more due to the reductions in trading costs attributable to more efficient processing of trading information and consequent reductions in costs.

        At this point the meme that HFT is the cause of just about every ill in society seems unstoppable, yet it’s nonsense, and it threatens this very real and very large benefit to the average saver. HFT equity profits are a tiny fraction of the profits investment banks make in large, opaque, uncompetitive fixed income markets, where HFT doesn’t exist. Their customers are paying for these profits due to the expensive market making services that occur when there is a lack of competition.

        HFT is a David vs. Goliath story, a number of very small entrepreneurial technology-centric firms have utilized the transparency and level playing fields induced by US law to essentially take over, at a small fraction of the cost, the bulk of market making and price discovery in US markets. This was an information arbitrage enabled by computers and modern information processing, much to the benefit of the average investor. The negative HFT meme is equivalent to the belief that “other people” are getting something for nothing. Nobody gets something for nothing, not in a fiercely competitive industry.

        HFT profits are a small fraction of the value created, the bulk of the savings flows to retail traders due to vastly smaller spreads, and vastly improved prices, it’s the exact opposite of what those who were displaced by better technology would like you to believe. It’s like any other competitive business, the end users en masse are the true winners. The competitive, exponential application of information processing technology to the US equity markets has uncovered a huge amount of inefficiency and corrected it because it’s now cheap enough to arbitrage it away at a profit. But most of the inefficiency that was arbed away flowed to the end users (retail traders), not to the HFT businesses.
        This is the natural outcome of a competitive application of technology where many participants are allowed to freely compete, nothing new here.

  5. What is striking is that IT is rapidly commoditised with margins heading in the direction of a commodity – towards p=mc. Meanwhile finance seems to be heading in the other direction. Why the contrast? A major reason is that finance is massively regulated. So there are heavy limitations on what disruption can be brought about. I pursue some of the policy implications of this here.

    http://www.lateraleconomics.com.au/outputs/Perspectives.pdf

    • Interesting paper, Nicholas. As you suggest, standardisation of financial products would make them more readily trade-able and therefore improve liquidity. I wonder how this is going? Assets in a securitised mortgage market could be irrevocably-linked to indices, which could be traded on a clearing exchange. Sounds too easy… 🙂

      Regarding marginal pricing, the tendency of product prices to move towards their marginal cost certainly exists. The trouble is, businesses that are forced to operate in this zone are nearly always at high risk of being forced to sell below cost and therefore are at high risk of failing.

      Since the costs to business owners of failure are usually very high, they will typically do whatever is required in order to avoid being marginal-cost sellers. This is just a matter of existential necessity and leads to a whole range of adaptive strategies.

      In practice, businesses try to work within the limitations of their scale and then to manage the composition of their top-line – their revenues – around their whole-of-business costs and their forward-looking business goals in their given market. Despite what the classical theory of the firm says about output pricing, I think firms use a very wide variety of pricing tools, and only very exceptionally would they employ classical marginal costing.

      In a practical sense, many businesses would not be able to define what their actual marginal costs of production are. Apart from anything else, these costs are likely to change frequently, depending on absolute volumes and varying input costs. The “p=mc” zone is a mathematical possibility but is also a no-go area for most businesses.

      In finance, of course many others beside the owners of financial businesses would lose if they were to fail. Because systemically important banks are now too-big-to-rescue, they are not required – or even permitted – to trade in the perilous “p=mc” zone.

      As you suggest, this strengthens the case for finding new ways to increase liquidity, competition, innovation and transparency in financial products. It also offers a way for markets rather than the state to carry some of the catastrophic risk inherent in finance.

  6. Karan, re inter bank transfers, they work pretty well if you pay your $22 transfer fee.
    Banks, more cub with the government than any other sector by a mile, at the detriment of everyone

  7. the phrase ‘financial innovation’ sounds
    like alchemy, snake oil, a term a grifter
    would use – all debts have to be
    paid, simple as that

    money for nothing (algos,HFT etc) is theft,there is always a counter party that
    is holding the empty bag

    the share market is a self inflicted casino gulag

  8. I listened to a futurist about 18 months ago and he suggested the real benefits and wealth are made about 80years after the original invention, but with severel bubbles along the way. Or false starts I think he called it.
    He also thought the cycle was getting shorter and believed in exponential growth but with a ceiling on stuff, so trains got better quickly but now haven’t continued their growth rate since.

  9. As interesting as it is to consider the massive influence of IT on finance, I find it more interesting to consider the impact of robotics, which is itself just starting out on an IT-driven exponential development curve, and as such is still invisible to most except those who follow the field closely.

    The “end-point” of robotics and AI development, if you will, is the destruction or usurpation of all jobs – or the automation of every productive activity, i.e. the point at which there is no productive contribution that a human can make to the economy that a robot cannot make quicker, faster, and cheaper.

    I discovered macrobusiness about 6 weeks ago and have been really enjoying the content. Economics is a neglected area of study for me and I’ve found the blog quite educational. I’d love to see the macroeconomics guys do a piece on such “technological unemployment”, characterised as it is by massive productivity growth and job losses leading to the theoretical paradox of ubiquitous cheap (free?) goods and services and no one with any money to buy them with.

  10. Exponential growth goes hand in hand with exponential decline elsewhere – laws of mass conservation (or energy conservation) seem to apply not only in physics or chemistry. Only difference to real physics and thus the simple mechanism of exchanging pure commodities is the ingenious idea of economists to monetize the individual “utility”. E.G. take two isolated islands: one is producing bananas only and this is their peoples’ only diet; likewise the other island growing only oranges and feeding on them. As soon as both start to exchange their produce the individual’s “utility” to have a different diet once in a while creates “value” – and problems. It initiates an exchange- and price- dynamics beyond simple exchange of material. In free nature both populations will grow exponentially and thus the need for their products. Some “banana”-people may have developed such a strong “utility” for oranges that they start behaving “unnatural” (working more than their peers, behaving antisocial, crime,…). Same for “oranges”-people…
    Maybe we need to curb the importance of “utility” and go back to a more physical level… That would be the end of marketing, advertising, management consulting, professional politics,…
    – all disciplines trying to influence/manipulate our “utilities”.

  11. Ahh, predicting things. So hard to do with better than average results, unless you are fixing the game of course. And isn’t that what some financial innovation is about, fixing the game?

    The human genome was finished over 2 years ahead of schedule, due to underestimating the impact computers would have on processing the data. But not everything is so data driven.

    I’ll take his bet on solar energy and medicine by the way 😉

  12. JPK and Nicholas Gruen, I think the thing that needs recognition is that finance IS rules. The regulation is not external to the thing being regulated. It is a case of self reference. If the implications of this were better understood the analysis of the financial crises would be more effective.

    • Although finance is rules there is no hope that there is a fixed set of rules that will achieve desirable outcome, whatever desirable outcome is, which will be external to finance e.g. support of the real economy. We know from the Godel’s Theorems that even trivial axiomatic systems are incomplete i.e. there will be statements in these systems that can neither be proven false or true. Therefore setting up and changing rules will be an ongoing process and its purpose should be external to finance e.g. banning naked short selling to protect companies targeted by such activity. The problem with setting up rules is that very often they lead to unintended consequences and create even bigger problems that they try to fix. Very often rules are bent in favour of narrow financial interests. The repeal of the Glass-Steagal Act is a good example of this. In an ideal world whoever sets up the rules should be honest and wise i.e. the rules must not favour narrow interests and should be thoroughly analysed to avoid unintended negative consequences. The latter can be to a large extent facilitated by IT through computer simulations. The research on debt by Steve Keen is a good example. The systems of differential equations that he constructs have virtually no hope of being analytically solved but who cares we just need to see trajectories for some initial conditions and then verify the model against real life data. It is all easier said than done especially that rules are set by politicians who either do not have intellectual capacity to understand complex issues or are too corrupt to act for the common good.

  13. If you read about the history of finance.
    You will quickly learn about the Perils of Financial Innovation.
    They use to say: It is all about the economy! Stupid!
    All roads lead to Rome!

    Now; it is all about technology! Stupid!
    All roads lead to IP!

  14. JPK,Someone who gets the importance of Godel!! Excellent. I wish the science community understood what he means, it might curb some of their hubris. If those who think they have solved the problem of risk understood Godel they might be a little more useful.
    I completely agree with this comment, especially about the need for a reference point external to finance finance:

    “Therefore setting up and changing rules will be an ongoing process and its purpose should be external to finance e.g. banning naked short selling to protect companies targeted by such activity. The problem with setting up rules is that very often they lead to unintended consequences and create even bigger problems that they try to fix.”

    The debate should be about what that external yardstick should be (morality, or utility) but I see no evidence of that occurring.

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