Too complex to succeed

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By David James.

A common observation is that the financial system got into trouble because of the invention of securities that were too complex for ordinary investors to understand. This is true, but it should be more closely examined. Warren Buffett is no doubt right in noting the sociological implications for the finance and business tribes: “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.” Such preference for complexity applies especially to the financial markets. If an investment strategy sounds complex the assumption tends to be that there is a high level of intelligence involved (true) and that this will result inevitably in better returns (probably false — witness the fate of Long Term Capital Management, not to mention the GFC).

In finance, the question should be asked — what is this complexity? It is the establishment of sophisticated new rules. Because, as I have long argued, money IS rules. The complexity is the creation of new, more sophisticated rules, and the insanity of what has happened in the financial system over the last decade is that traders, not governments, have been allowed to make up their own rules. The basic rules of money, such as those applying to bonds, shares, insurance, have been overlaid with increasingly complex meta-rules created, in many cases, by scientists formerly from NASA. Two of these new rules, collateralised debt obligations and credit default swaps, almost destroyed the world’s system of money in 2008.

I am sorry if this is getting a bit repetitive, but until this is understood, no solution will be found; the danger will persist. It is a simple case of a popular metaphor deluding everyone. For example Terri Duhon, the JP Morgan banker commented in a documentary that she thought credit default swaps were fine because they created credit and credit is the “lifeblood” of the economy.

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Note the metaphor. Blood. Coursing through the veins of a body. Sounds fine, but it is false. Credit is a transaction, an agreement between people that allows them to behave in a particular way with confidence. It is not a fluid. Neither is it the case that if more of this “fluid” is created that everything will improve, the body will be flush with colour or something. What happens is that more people are able to transact, which relies entirely on how the basis of those transactions will hold good.

And what is the basis of the transactions? A set of rules. Obviously, if excesses occur, then the rules will not hold up. It becomes even more dangerous when new rules are invented, creating multiple layers of rules. Not only does this put more pressure on the basic rules. For example, the more mortgage securitisation you have (CDOs etc), the more it imperils the basic rule of a mortgage, that the bank lends you money to buy a house and you pay it back in a certain time.

You also add the extra risk that there will be too much pressure on the new rules as well. In other words, the more rules you allow people to make up, the more chance that some of them will fail at some point. And then you imperil the very system of rules that is money, which is exactly what happened. Paul Kanjorski, former chairman of the subcommittee on Capital Markets said that on a Thursday in September 2008 $550 billion was drawn out of US money market accounts in one morning:

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The Treasury … pumped $105 billion into the system and quickly realised they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts, and announce a guarantee of $250,000 per account so there wouldn’t be further panic …
If they had not done that their estimation was that by 2pm, $5.5 trillion would have been drawn out of the money market system of the United States, [collapsing the national economy] and within 24 hours the world economy would have collapsed. It would have been the end of our political and economic systems …

This is what a collapse in the system of rules looks like. In this case, the Treasury was able to impose a rule of guarantee that saved the system. If not, money itself would have been imperilled.

There is a further problem with allowing such a complex system of rules to be created. It is that the rule system becomes a law unto itself, a rule system that generates its own rules and logics, eventually becoming unmanageable. This is what the absurdity of high frequency trading is inclining towards. This is the application of algorithms to the basic rules of finance which sets off a chain of new algorithms, followed by algorithms that chase those algorithms and so on. All justified by calling it extra “liquidity” (another fluid metaphor).

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Once again, it is just an increased frequency of transactions that relies on the basic rules of markets to exist. Eventually it will result in either the basic rules failing or the sophisticated rules failing. There is only one solution. Stopping the financial sector from making up its own rules. (Moving back to a gold standard, I might add, may limit some of the rule making debauch, but gold mainly has value because that is the rule. It is just the rule made more physical.)

Instead, governments are encouraging them, as the New York Times notes:

Which institutions hit this jackpot? Clearinghouses. These are large, powerful institutions that clear or settle options, bond and derivatives trades. They include the Chicago Mercantile Exchange, the Intercontinental Exchange and the Options Clearing Corporation. All were designated as systemically important financial market utilities under Title VIII of Dodd-Frank. People often refer to these institutions as utilities, but that’s not quite right. Many of these enterprises run lucrative businesses, have shareholders and reward their executives handsomely. Last year, the CME Group, the parent company of the Chicago Mercantile Exchange, generated almost $3.3 billion in revenue. Its chief executive, Craig S. Donohue, received $3.9 million in compensation and held an additional $10 million worth of equity awards outstanding, according to the company’s proxy statement.

Make no mistake: these institutions are stretching the federal safety net. The Chicago Merc clears derivatives contracts with a notional value in the trillions of dollars. I.C.E. clears most of the credit default swaps in the United States — billions of dollars a day, on paper. No wonder they are considered major players in our financial system.

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Nothing, in short, has been learned.