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).
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.
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.
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.
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.
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.
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.
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).
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.
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.
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).
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.
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
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!
> 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.)
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.)
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.
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.
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.
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.
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.
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.
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.
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.
> 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!
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.)
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.
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.
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).
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