My Unspeakable Observations On Finance
January 7, 2011 8 Comments
Lots of people have a lot of ideas regarding the financial system, what went wrong, and how it should be fixed. For example, Dodd-Frank, or ‘let’s cap leverage’, or my personal favorite, ‘what if we just banned all derivatives?’
In case it might help advance the discussion, let me lay out some principles of finance/banking that I have observed and amassed:
- The primary endeavor of finance is to try to extract maximum value from capital within the letter of the law. One corollary is that ‘let’s make better regulations’ is never the solution to any problem. Okay, make your regulations, revise them, etc. Big deal. The finance world will read them, analyze them, and then figure out how best to push, stretch, and route around them. That is precisely what they do. I honestly don’t know what the ‘better/more regulation’ dreamers and fetishists think they’re accomplishing. Ever. In fact, more regulations just means that the task of ‘figuring out how to extract value within the regulations’ gets that much more technical and difficult, requiring that much more skill and added-value – in other words, it practically guarantees ever-increasingly obscene compensation in finance. If this is the outcome you seek, lefty, then fine, but don’t kid yourself about what you’re doing.
- (Relatedly) A large and largely-unnoticed effect of ‘regulations’ is to create pointless, zero-productivity jobs for overeducated people who want and demand six-figure incomes doing something, and to guarantee similar lifestyles for their kids. The more regulations you write, the more people will get jobs in ‘compliance’. Or as the ‘chief operating officer’ (which, as far as I can tell, is something like a ‘corporate mommy’). Or ‘reporting’. Or ‘consulting’. This means plenty of jobs for people in cufflinks or pants-suits, having meetings with each other and making Important reports about how the banks are compliant with this and that, or collating numbers together to prove that banks are measuring their risk appropriately, and then submitting their Important findings to the government (to be filed away in Important file cabinets), and then doing it again next quarter, and so on, for a lifetime of reasonably well-paid (or in some cases perhaps even ridiculously-well-paid) pathetic make-work. They will live middle- to upper-middle-class lives, many will send their kids to private schools, and those kids will grow up to be bond traders. If this is the outcome you seek, oh so egalitarian lefties – creating, maintaining, and paying a permanent technocratic overclass that produces no product of any value (not even just pure PnL!) – then fine. But don’t kid yourself that you’re doing it to help out Iowa truck drivers or Louisiana fisherman. You’re effectively doing it to help out your classmates from Brown.
- The supposed bright line between ‘market making’ and ‘prop trading’ is a complete fiction. Often people toss out these ideas to ‘ban prop trading’, or to better wall off prop trading, or ban certain sorts of trades ‘unless they are purely hedges’. This is all nonsense, much of it incomprehensible, as if made up by someone with no knowledge of the subject. To be sure there is this nice polite fiction, or fantasy, among some – and nurtured by the banks themselves obviously – that there is such a thing as a pure market-maker role that takes no risk, and so if we could somehow confine banks to doing only that, all will be well. But market-making without ever taking a position is unrealistic, and there is no logical way I have ever heard anyone articulate of circumscribing what constitutes ‘prop trading’ and what doesn’t (nor can you, in finite time, ever hope to work out which positions constitute ‘hedges’ vs naked positioning – for starters, at which level of aggregation?). If a market maker, seeing customer flows and anticipating the direction of the market, positions himself ahead of the flow, makes PnL from smart positioning, then exits the position a bit later at a profit, was that a ‘prop trade’? Why or why not? Show your work. I honestly don’t know, because it’s a phony distinction. Some (market-maker) traders will tell you that they make most of their PnL from doing what is essentially prop trading (and, which is typically trading the risk/control groups try to prevent them from doing), and the market-making side is small potatoes, if not an outright burden to have to provide liquidity for clients. Taken seriously, this means that what banks get most profit out of doing, they have to pretend (even to the point of hiring teams of people to try to stop it) not to be doing it. This is a schizophrenic situation and it’s not clear why the whole kabuki dance is even necessary.
- The lack of knowledge of would-be regulators/controllers is inevitable and insurmountable. A lot of regulation and thinking about control/management is tacitly premised on a superhuman amount of ground-level knowledge about the detailed trades and positioning at the desk level, knowledge that simply can and will never obtain in the real world. For much the same reason that Communist central-planning fails, the technocratic/regulatory mindset fails: the technocrats don’t and can’t know what they’re doing or talking about. Often/usually not even the head of the actual desk inside the bank itself will have much trade-level detail about what’s going on in one of his trader’s books; the head of a division will only have a vague idea; the head of the investment bank will only know some very gross and aggregate (in some cases, e.g. VaR, mostly meaningless) numbers prepared lovingly for him by others. A recent seemingly-desperate, grasping response to this problem is to just demand that banks throw an ever-increasing amount of data (risk metrics and such) at regulators, in what is either a shotgun approach (‘let’s just ask for everything and maybe that will help’) or an attempt at CYA (‘we couldn’t have possibly asked for more’). What the regulators, or the Fed, or whoever, think they are going to do with all these terabytes of data from all the banks is beyond me. Besides employ a bunch of IT and techie people to try read/interpret them. (See above re: make-work jobs.) Even if they were capable of dealing with it and analyzing it (which they’re not) what would they actually do. The point is that as the financial system gets geometrically complex and globalized,
central plannersregulators naturally have less % of the information they’d need to achieve their aspirations, not more, and this only gets worse over time, not better, and asking for a geometrically-increasing amount of data you can’t possibly do anything with is no solution. Regulatory approaches that don’t take this issue into account are retarded.
- The concept/crime of ‘insider trading’ is incoherent and it should just be legalized. A lot of stuff takes place legally every day that to me is logically indistinguishable from ‘insider trading’. This rule and rules like it seem more image than substance; the aim is plainly to instill ‘confidence’ in the market so that people will play in it. So if that’s why it’s needed, then fine, but let’s not kid ourselves that such measures (and other, more Puritanical rules about markets and what their participants can/can’t do) have anything to do with protecting the common person or are in any way ‘progressive’. ‘Confidence’ is of course the etymological root of the word ‘con’. Keeping up appearances so that people stay fooled and the con game can go on is not an egalitarian, populist aim.
I could go on but my opinions/assertions would just get more heterodox and unmentionable from here. The point is, these views of mine, formed by observation, are at such variance with conventional wisdom, such a 180-degrees rotation from what most people think, that for me to follow news, commentary and debate on finance, regulation, and related issues practically causes me physical pain.
The saving grace is that maybe I am wrong about some/all of these things so if you have reason to believe that is the case then feel free to speak up (you’d be doing me a favor), but as of now I’ve seen no reason to think that I am wrong or that the chattering classes know what the hell they’re talking about regarding any of this – unless of course they continue to pursue this retardedly technocratic approach to regulation in full knowledge that they are self-servingly supporting the upper class, their own salaries, and their gifted childrens’ futures as bond traders in doing so.