26 ms·

Why is finance so complex? (2011)

164 points by mayukh 11y ago

fsk 11y ago
Finance is complex because: 1. If a transaction is complex, it's easy to sucker people into buying. Why would anyone buy a structured product? 2. If a transaction is complex, both sides can claim an immediate profit based on their idea of how it should be valued. 3. A lot of complexity in finance is driven by the fact that big banks can borrow at 0% while true inflation is higher. Via various derivatives, this government interest rate subsidy is packaged and sold. For example, I can't borrow at 0% to buy stock, but if I buy a call option, the bank can borrow at 0% to finance their hedge. 4. Because different people have different interest rates (banks borrow at 0%, large corporations borrow at 5%), banks can price a derivative at 3%, and both sides can LEGITIMATELY claim an immediate profit on the trade. (Bank borrows at 0% and lends at 3% to finance the derivative hedge. The corporation is borrowing at 3% instead of the 5% they normally would pay.)
- britknight 11y ago
  Banks don't necessarily borrow at 0%. Granted, they are able to borrow at a much lower rate than you or me (closer to the Federal Funds Rate managed by the U.S. Federal Reserve), but they still pay interest on their loans. Of course, real interest rates have gotten close to zero, but in general real interest rates of 0% are nonsensical in stable, developed economies. Economically speaking, if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider.
  - jameshart 11y ago
    "if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider" Wait, run that by me again more slowly. In general, it does make sense to make large infrastructure investments in order to increase long term productivity, especially when interest rates are low, but in general, it's always the case. Hell, bits of the Rockies WERE bulldozed (And dynamited) to save money on railroad or freeway construction that would pay off on a fifty to a hundred year timescale. What does zero percent interest have to do with that? Presumably there are even some positive interest rate values for which the eventual gas savings outweigh the cost of hiring the guys with the bulldozers, if those are the only costs you care about. If there's a quadrillion dollars worth of hydrocarbons on Titan, and it'll cost me a trillion dollars and fifty years to bring them to earth, it makes economic sense for me to do it, even if interest rates are 5%. I don't think it's the interest rate that makes these projects make sense or not make sense. What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?
    - civilian 11y ago
      Exactly. I think he's assuming he'll never have to pay back the principle.
      - britknight 11y ago
        (In response to above as well as parent) > What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense? The bulldozing-mountains example is purposefully over-the-top (I believe I first heard it in an article by Bernanke[0]). The point that I am trying to illustrate is that at a 0% interest rate, the traditional marginal cost/marginal utility analysis breaks down, since as long as the marginal utility of the last investment dollar spent outweighs the marginal cost of spending that dollar (the interest rate), traditional economic thinking would have you spend that dollar. > Exactly. I think he's assuming he'll never have to pay back the principle. The rocky-mountain example does assume this, but it doesn't make a 0% interest rate any more ludicrous. Imagine that you could take out a loan for $x at 0%. Simply because of the fact that time gives assets the opportunity to grow, the future value of that loan when it is to be repaid is greater than the value when you received the loan [1]. Of course, the 0% rate would remove some traditional investment options (savings account, Treasury bonds, etc.), I think it is reasonable to assume that investments will still be able to appreciate to some degree. However, this appreciation would be constrained in reality by inflation if the real interest rate is 0%. If, on the other hand, the nominal interest rate is 0%, then the loan effectively counteracts the headwind of inflation, and any return, no matter how small, winds up in your pocket. [0 (7th paragraph)] http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31-why-interest-rates-low-secular-stagnation http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31... [1] https://en.wikipedia.org/wiki/Time_value_of_money https://en.wikipedia.org/wiki/Time_value_of_money
        dllthomas 11y ago
        Time gives the money a chance to grow if there is anywhere that offers a safe return. Lending at a negative interest rate is paying someone to keep your money safe. Borrowing at a real negative interest rate may not make sense if you aren't sure you can do that.
  - stretchwithme 11y ago
    Its possible to borrow money, blow through the cash on some unproductive investment and then be unable to repay the principle on the agreed-upon schedule.
pbreit 11y ago
Credit (including fractional reserves) definitely makes things a lot more common located.
pgwhalen 11y ago
Financiers are buyers and sellers of risk. They do so at prices that are generally advantageous to them. They are able to do so because they make a profession out of it: they have a lot of capital to work with, and they spend a lot of time thinking about it. To call finance intentionally opaque is a perhaps true, but it shouldn't be vilified much more than other goods and services, the providers which all maintain some level of "opacity" towards their customers. In a sense, it's a fundamental part of any capitalistic transaction. A farmer sells an apple for more than it costs for her to make it, but you're willing to pay her for it because you aren't that good at growing apples. To her, it might be worth what it cost her to grow it, but to you, it is clearly worth what you are willing to pay for it, because you have the added benefit (or requirement) of being able to eat it and survive. So it is worth more to you, less to her, and she profits. One could see similarities in insurance (much closer to finance than apple-growing, if not finance itself). An insurer charges you (or maybe an aggregated group of "yous") more than it costs to provide a certain protection (or hedge against a certain risk). You are willing to pay the premium because clearly the risk protection matters more than getting some "theoretically optimal" price. With increased availability in technology and information, certain kinds of finance are becoming easy to do "on your own" - the most salient example is perhaps index investing. Many people are realizing that financiers cannot add value and they need less of a middleman. I thought I'd share my contrasting thoughts, but I very much enjoyed the read.
applecore 11y ago
Consider that the Brownian model of financial markets was discovered by Bachelier in 1900, five years before Einstein, and the pace of financial innovation in the intervening century, and you have your answer for why finance is complex. [1]: https://en.wikipedia.org/wiki/Louis_Bachelier https://en.wikipedia.org/wiki/Louis_Bachelier
- aet 11y ago
  The only good innovation in the intervening century was the ATM..
johnloeber 11y ago
The fundamental reason is because we may create financial products. They can be socially very useful, they may endow their creators with vast profits, or both. So the creation of financial products is strongly incentivized both from the buyer- and seller-sides. However, there are only really two things that we can use to create these products: debt and risk. Thus, when we try to create financial products, we create structures composed entirely of debt and risk, which become very complex. The reason why they become so complex is similar to any other case in which you try to make highly sophisticated structures from only very simple/basic components: there ends up being a great number of details.
slg 11y ago
>The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear. That is a pretty loaded statement. That would be like saying the core purpose of the software industry is to destroy jobs and in turn collect part of the salary that those jobs previously paid. It might technically be true, but it is twisting things to make them sound intentionally evil.
- justicezyx 11y ago
  The description does not convey the idea that the idea is evil.
- pessimizer 11y ago
  But it's actually true. I've personally had the experience (as a freelancer) of watching people that I had just recently met be laid off because of what I was being generously paid to do. I did not like it. I could at least comfort myself by the fact that what I was doing was actually useful (and creating efficiencies that destroyed jobs), whereas concealing risk is actively deceitful and destructive.
  - Lorento 11y ago
    According to the article though, this deceitfulness is actually good, not destructive. It puts us into a more productive Nash equilibrium than we'd be if we each individually assessed the risk of our single investment and said "na, too risky".
  - techbio 11y ago
    Efficiency is therefore deliberately harmful, except when in the form of a paycheck, QED. Well done, good luck.
Tycho 11y ago
Derivatives are instruments for transferring risk from those who understand it to those who do not.
jerf 11y ago
Article appears to answer the question why does finance exist, not why is it so complex. I think the answer for why is it so complex is that it is a human domain that rewards complexity. First, humans that turn their full brain power on something inevitably make complicated structures. If you think about it, this becomes clear that it's true, even if there's absolutely nothing there. For instance, it's almost worth picking up a practitioner's book on numerology or astrology, a really "good" book that goes deep into the details and history, not just a superficial "intro" jobber, to witness the incredible complexity humans bring into a field that 90%+ of the readers of this comment will agree there is virtually no reason for it to possess, because there's no "there" there. How much more complexity and richness we can bring to an already complex field! And as others are pointing out already, finance also rewards complexity, both because people can hide things in the complexity and because people can fool themselves into thinking they understand the complex things, and because the interaction of all these complex things is even more complex. You want another domain that works much like that? Consider any ol' pile of code that a software company runs on. It's bad enough that all software companies of any size are trying to solve a non-trivial problem, but throw a few hundred random developers at it and before you know it the "simple billing system" has 100-line buggy sorting functions sitting next to the double-booking accounting algorithms and all the other endless monstrosities we sometimes swap stories about on HN or various reddits. And then one day a trivial quirk in that sorting algorithm accidentally erases all the data in your customer database when it accidentally decided everybody had failed to pay their balances for over a thousand years or something. Computing is complicated even before humans start humaning the place up, but then it gets even worse.
h8trswana8 11y ago
The world of finance makes these aspects of your life function: * Allows you to get a mortgage * Allows you to protect yourself with health/car/life/home/title/etc insurance * Pays for your highways/stadiums/schools and other public works * Protects your deposits * Pays for your retirement * Funds the college fund that paid for your school * ... Or the student loans that allowed you to attend school * Supports the global supply chain that brings you your iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back. * Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone * Funds the massive philanthropy expenditures that help those in need everyday * Pays the pensions of the elderly Financial innovation make our lives more predictable and less sensitive to chance. One could argue a huge amount of human progress is owed to modern-day financial institutions. Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten. Finance is an art, not a science. Sometimes we make products that we don't always completely understand until later. But the vast majority of financial innovations are deeply ingrained in the good life that you get to enjoy every day.
- branchless 11y ago
  Allows you to get a mortgage which is a function of available credit which is near limitless and so becomes a function of your expected lifetime earnings. Times two now they lend at "household" income. Education prices are also a function of available credit that tops out at expected total salary less food/rent expenses. It's enslaving you. Unless you ride it and enslave others. Your list reads like a wide-eyed econ grad. This is not the real world. Also note the "we" in the statement. Vested interest.
- Spooky23 11y ago
  All of these were done 25, 50, or 100 years ago. The basis for the mortgage industry as we know it was developed during the new deal. I need some serious convincing that the effects securitization of everything has been a net win. The markets for most of this stuff are made or directly supported by the Federal government.
  - 11y ago
reactor 11y ago
https://www.youtube.com/watch?v=iFDe5kUUyT0 https://www.youtube.com/watch?v=iFDe5kUUyT0 series is a good watch and will give you an idea why they "made" it complex.
icanhackit 11y ago
Animal spirits are game theory Human behavior is a large part of the complexity because we try to use things like game theory to predict how someone will act based on a confined set of conditions which totally ignore the very long game which has been playing from long in the past and will continue long in the future. There are too many factors to account for which can make an actor appear irrational given the posited conditions, however the truth is there can never be a rational actor until we map every input and interaction in someones life. This is why the idea of a rational actor is horseshit. Nick Szabo did a recent post that covers this: A small-game fallacy occurs when game theorists, economists, or others trying to apply game-theoretic or microeconomic techniques to real-world problems, posit a simple, and thus cognizable, interaction, under a very limited and precise set of rules, whereas real-world analogous situations take place within longer-term and vastly more complicated games with many more players: "the games of life". http://unenumerated.blogspot.com.au/2015/05/small-game-fallacies.html http://unenumerated.blogspot.com.au/2015/05/small-game-falla...
brownbat 11y ago
Or, some investment decisions resemble Keynesian beauty contests: https://en.wikipedia.org/wiki/Keynesian_beauty_contest https://en.wikipedia.org/wiki/Keynesian_beauty_contest
querious 11y ago
I think of it as an arms race between traders and regulators. The more complex the security, the longer it will take regulators to pass rules against its misuse, figure out taxation, etc. In the meantime, the inventor stands to make an enormous amount of money. Also, there's an inherent information asymmetry favoring the inventor.
curiousjorge 11y ago
because it attempts to quantify and model the unpredictable and lot of people are paid very well to keep that image going for as long as they can.
conductr 11y ago
Because telling the future is complex
hartator 11y ago
Taxes also had a lot to do of the complexity of the system.
rcarrigan87 11y ago
Finance is just a set of tools. Just like anything else it really comes down to the moral fiber of the individual wielding that tool. Fischer Black and Myron Scholes weren't sitting in front of their white board thinking about all the people they could rip off. They were genuinely trying to find a way to price options as a tool to mitigate risk. I can use a hammer to build a house or sink the hammer into my enemies head. Either way, it's still a hammer.
innguest 11y ago
"The study of money, above all other fields in economics, is the one in which complexity is used to disguise truth or to evade truth, not to reveal it." John Kenneth Galbraith, Money: Whence It Came, Where It Went (1975), p. 5
hiram112 11y ago
FWIW, I'm relatively quick, pick up languages (both CS and natural), frameworks, algorithms, etc. without much trouble. But I've tried again and again to understand how our basic Federal Reserve System functions - Gov't debt, banks, reserve margins, mortgage loans, etc. etc. I've NEVER gotten a basic "THIS IS HOW IT WORKS in 21 DAYS", Stack Exchange-type-answer. Lots of opinions... This itself leads me to believe that Finance is corrupt. I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs. T. Jefferson
- iolothebard 11y ago
  Lmao, can't understand it so it's corrupt. Sounds like all the people that think the same about IT. It's "magic". Buy and read some books, it's laid out pretty clearly. If you're not sure what to read, email some of the professors in finance at the University you went to.
  - Sone7 11y ago
    I'm curious what makes you so sure you really understand it? It seems to me that when wealth is being concentrated more and more into the hands of the wealthiest all over the world, there is something deeply wrong with the financial industry and its textbooks.
    - iolothebard 11y ago
      Lol, degrees in finance and econ. Years of working in the industry as well. Why do you think people in finance aren't the ones being eaten up by increasing productivity and stagnant wages? I got out of the field because I thought IT would be more rewarding. If I had it to do over again, I'd be one of those finance assholes ripping everyone off and laughing all the way to the bank.
Animats 11y ago
"The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear." This. If you have money, and let it be known that you have money, you will be offered a large number of stupid deals. There is a huge range of financial products out there which underperform the market. Amazingly, people buy them. Wealthy people. The deals offered poor people, such as payday loans, and crap auto loans, suck even worse. Most Americans were better off when we had regulated savings and loans, tightly regulated banks, and a much narrower range of financial products.
erebus_rex 11y ago
The inherent role of finance is NOT to hide risk. Its role is to connect people who have one type of asset they no longer want with someone who does. In that way bankers are just like lawyers and accountants. You pay someone to do things you don't have the time to do (or even learn how to do) so you can focus on your job. Its division of labour at the macroeconomic level and everyone benefits from specialisation. Now, I agree that contemporary finance is bloated with opacity and that banks do benefit from this via corruption (tax code and compliance reform are needed ASAP). But its disingenuous to say that the value of finance is entirely "placebo".
kmonad 11y ago
Curiously, placebos work even if the patient knows it is a placebo. Hence http://placebobutton.com/ http://placebobutton.com/ More on topic, this article is full of red herrings and poor analogies such as the above. Why on earth would you use game theory's payoff matrices as an analogy to what could perfectly be put into words? The authors thoughts on "financial institutions buffering fear" really don't require invocation of another complex framework unless he somehow wants to derive credibility from this, which would of course be poor form.
KaiserPro 11y ago
Finance is not complex. It really isn't. if you know the right people you can find out all the information you need. However: The very foundations of Finance are built on sand What do I mean by that? Finance is built on the concept of value, or worth. "How much is this gold worth?", "how much is the client willing to pay for this service?" The concept of value and worth are subjective. They are in the eye of the beholder: If you ask a thirsty backpacker stranded in the middle of the Sahara: How much are you willing to pay for a 2 litre bottle of water? The answer, most likely is many monies & possible limbs. Now trying flogging the same water to city trader in a champagne bar. I can hear you scoffing, "Oh but that's a silly example, the backpacker was practically dead" Correct, worth is subjective. Its based on your circumstances. There are many other examples, the Turner painting in a jumble sale, the sale of a sports car when the wife becomes pregnant, etc, etc. Complex derivatives are really not complex. They are normally a "RAID" of different types of contracts. What then happens is the end user is deliberately bamboozled into not asking questions.
jackgavigan 11y ago
Finance is complex because it's basically math. And math can get very complex.
ostyn 11y ago
Definitely read "fiance". Maybe I'm just projecting.
bakhy 11y ago
This reminded me of the concept of demurrage in currency [1]. The idea was brought up to solve that exact problem. The messy system of inflationary fiat currencies won, and even though it is probably better and more practical, the demurrage would have had the advantage of making it clear what we're trying to achieve. Inflation seems to be hated by many people which, judging from their other political viewpoints, should be supportive of it... [1] https://en.wikipedia.org/wiki/Demurrage_%28currency%29 https://en.wikipedia.org/wiki/Demurrage_%28currency%29
fiatmoney 11y ago
There was a nice result a while back that the efficient market hypothesis is true IFF P=NP. http://arxiv.org/pdf/1002.2284.pdf http://arxiv.org/pdf/1002.2284.pdf
ryeguy_24 11y ago
I disagree with the main thesis here. The author states that complexity is due to opacity. This may be true in some cases but there are a number of complexities in finance that are not opaque. For example, look at all the optionality and contingent payouts in an 'Power Reverse Dual Currency' derivative. It's a really complex thing. However, the term sheets tell you everything about the transaction and the ultimate payout of the derivative (it may be 50 pages long, but it's all there). To say that all things in finance are complex because they are opaque is pretty wrong. Maybe the author is talking about a different dimension of finance (e.g. the unpredictability of human behavior, I mean sure, that's opaque, but that's not finance).

164 points by mayukh 11y ago

fsk 11y ago

Finance is complex because: 1. If a transaction is complex, it's easy to sucker people into buying. Why would anyone buy a structured product? 2. If a transaction is complex, both sides can claim an immediate profit based on their idea of how it should be valued. 3. A lot of complexity in finance is driven by the fact that big banks can borrow at 0% while true inflation is higher. Via various derivatives, this government interest rate subsidy is packaged and sold. For example, I can't borrow at 0% to buy stock, but if I buy a call option, the bank can borrow at 0% to finance their hedge. 4. Because different people have different interest rates (banks borrow at 0%, large corporations borrow at 5%), banks can price a derivative at 3%, and both sides can LEGITIMATELY claim an immediate profit on the trade. (Bank borrows at 0% and lends at 3% to finance the derivative hedge. The corporation is borrowing at 3% instead of the 5% they normally would pay.)

britknight 11y ago
Banks don't necessarily borrow at 0%. Granted, they are able to borrow at a much lower rate than you or me (closer to the Federal Funds Rate managed by the U.S. Federal Reserve), but they still pay interest on their loans. Of course, real interest rates have gotten close to zero, but in general real interest rates of 0% are nonsensical in stable, developed economies. Economically speaking, if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider.
- jameshart 11y ago
  "if rates were 0%, it would in the long run make sense to bulldoze the rocky mountains to save money on gas, because there is no marginal cost to consider" Wait, run that by me again more slowly. In general, it does make sense to make large infrastructure investments in order to increase long term productivity, especially when interest rates are low, but in general, it's always the case. Hell, bits of the Rockies WERE bulldozed (And dynamited) to save money on railroad or freeway construction that would pay off on a fifty to a hundred year timescale. What does zero percent interest have to do with that? Presumably there are even some positive interest rate values for which the eventual gas savings outweigh the cost of hiring the guys with the bulldozers, if those are the only costs you care about. If there's a quadrillion dollars worth of hydrocarbons on Titan, and it'll cost me a trillion dollars and fifty years to bring them to earth, it makes economic sense for me to do it, even if interest rates are 5%. I don't think it's the interest rate that makes these projects make sense or not make sense. What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense?
  - civilian 11y ago
    Exactly. I think he's assuming he'll never have to pay back the principle.
    - britknight 11y ago
      (In response to above as well as parent) > What's the magic that happens at zero that causes otherwise nonsensical projects to make economic sense? The bulldozing-mountains example is purposefully over-the-top (I believe I first heard it in an article by Bernanke[0]). The point that I am trying to illustrate is that at a 0% interest rate, the traditional marginal cost/marginal utility analysis breaks down, since as long as the marginal utility of the last investment dollar spent outweighs the marginal cost of spending that dollar (the interest rate), traditional economic thinking would have you spend that dollar. > Exactly. I think he's assuming he'll never have to pay back the principle. The rocky-mountain example does assume this, but it doesn't make a 0% interest rate any more ludicrous. Imagine that you could take out a loan for $x at 0%. Simply because of the fact that time gives assets the opportunity to grow, the future value of that loan when it is to be repaid is greater than the value when you received the loan [1]. Of course, the 0% rate would remove some traditional investment options (savings account, Treasury bonds, etc.), I think it is reasonable to assume that investments will still be able to appreciate to some degree. However, this appreciation would be constrained in reality by inflation if the real interest rate is 0%. If, on the other hand, the nominal interest rate is 0%, then the loan effectively counteracts the headwind of inflation, and any return, no matter how small, winds up in your pocket. [0 (7th paragraph)] http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31-why-interest-rates-low-secular-stagnation http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31... [1] https://en.wikipedia.org/wiki/Time_value_of_money https://en.wikipedia.org/wiki/Time_value_of_money
      - dllthomas 11y ago
        Time gives the money a chance to grow if there is anywhere that offers a safe return. Lending at a negative interest rate is paying someone to keep your money safe. Borrowing at a real negative interest rate may not make sense if you aren't sure you can do that.
- stretchwithme 11y ago
  Its possible to borrow money, blow through the cash on some unproductive investment and then be unable to repay the principle on the agreed-upon schedule.

pbreit 11y ago

Credit (including fractional reserves) definitely makes things a lot more common located.

pgwhalen 11y ago

Financiers are buyers and sellers of risk. They do so at prices that are generally advantageous to them. They are able to do so because they make a profession out of it: they have a lot of capital to work with, and they spend a lot of time thinking about it. To call finance intentionally opaque is a perhaps true, but it shouldn't be vilified much more than other goods and services, the providers which all maintain some level of "opacity" towards their customers. In a sense, it's a fundamental part of any capitalistic transaction. A farmer sells an apple for more than it costs for her to make it, but you're willing to pay her for it because you aren't that good at growing apples. To her, it might be worth what it cost her to grow it, but to you, it is clearly worth what you are willing to pay for it, because you have the added benefit (or requirement) of being able to eat it and survive. So it is worth more to you, less to her, and she profits. One could see similarities in insurance (much closer to finance than apple-growing, if not finance itself). An insurer charges you (or maybe an aggregated group of "yous") more than it costs to provide a certain protection (or hedge against a certain risk). You are willing to pay the premium because clearly the risk protection matters more than getting some "theoretically optimal" price. With increased availability in technology and information, certain kinds of finance are becoming easy to do "on your own" - the most salient example is perhaps index investing. Many people are realizing that financiers cannot add value and they need less of a middleman. I thought I'd share my contrasting thoughts, but I very much enjoyed the read.

applecore 11y ago

Consider that the Brownian model of financial markets was discovered by Bachelier in 1900, five years before Einstein, and the pace of financial innovation in the intervening century, and you have your answer for why finance is complex. [1]: https://en.wikipedia.org/wiki/Louis_Bachelier https://en.wikipedia.org/wiki/Louis_Bachelier

aet 11y ago
The only good innovation in the intervening century was the ATM..

johnloeber 11y ago

The fundamental reason is because we may create financial products. They can be socially very useful, they may endow their creators with vast profits, or both. So the creation of financial products is strongly incentivized both from the buyer- and seller-sides. However, there are only really two things that we can use to create these products: debt and risk. Thus, when we try to create financial products, we create structures composed entirely of debt and risk, which become very complex. The reason why they become so complex is similar to any other case in which you try to make highly sophisticated structures from only very simple/basic components: there ends up being a great number of details.

slg 11y ago

>The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear. That is a pretty loaded statement. That would be like saying the core purpose of the software industry is to destroy jobs and in turn collect part of the salary that those jobs previously paid. It might technically be true, but it is twisting things to make them sound intentionally evil.

justicezyx 11y ago
The description does not convey the idea that the idea is evil.
pessimizer 11y ago
But it's actually true. I've personally had the experience (as a freelancer) of watching people that I had just recently met be laid off because of what I was being generously paid to do. I did not like it. I could at least comfort myself by the fact that what I was doing was actually useful (and creating efficiencies that destroyed jobs), whereas concealing risk is actively deceitful and destructive.
- Lorento 11y ago
  According to the article though, this deceitfulness is actually good, not destructive. It puts us into a more productive Nash equilibrium than we'd be if we each individually assessed the risk of our single investment and said "na, too risky".
- techbio 11y ago
  Efficiency is therefore deliberately harmful, except when in the form of a paycheck, QED. Well done, good luck.

Tycho 11y ago

Derivatives are instruments for transferring risk from those who understand it to those who do not.

jerf 11y ago

Article appears to answer the question why does finance exist, not why is it so complex. I think the answer for why is it so complex is that it is a human domain that rewards complexity. First, humans that turn their full brain power on something inevitably make complicated structures. If you think about it, this becomes clear that it's true, even if there's absolutely nothing there. For instance, it's almost worth picking up a practitioner's book on numerology or astrology, a really "good" book that goes deep into the details and history, not just a superficial "intro" jobber, to witness the incredible complexity humans bring into a field that 90%+ of the readers of this comment will agree there is virtually no reason for it to possess, because there's no "there" there. How much more complexity and richness we can bring to an already complex field! And as others are pointing out already, finance also rewards complexity, both because people can hide things in the complexity and because people can fool themselves into thinking they understand the complex things, and because the interaction of all these complex things is even more complex. You want another domain that works much like that? Consider any ol' pile of code that a software company runs on. It's bad enough that all software companies of any size are trying to solve a non-trivial problem, but throw a few hundred random developers at it and before you know it the "simple billing system" has 100-line buggy sorting functions sitting next to the double-booking accounting algorithms and all the other endless monstrosities we sometimes swap stories about on HN or various reddits. And then one day a trivial quirk in that sorting algorithm accidentally erases all the data in your customer database when it accidentally decided everybody had failed to pay their balances for over a thousand years or something. Computing is complicated even before humans start humaning the place up, but then it gets even worse.

h8trswana8 11y ago

The world of finance makes these aspects of your life function: * Allows you to get a mortgage * Allows you to protect yourself with health/car/life/home/title/etc insurance * Pays for your highways/stadiums/schools and other public works * Protects your deposits * Pays for your retirement * Funds the college fund that paid for your school * ... Or the student loans that allowed you to attend school * Supports the global supply chain that brings you your iPhone, stocks the grocery store/your favorite restaurants with food, and puts the clothes on your back. * Funds the growth of corporations large and small, giving you the job that allows you to buy an iPhone * Funds the massive philanthropy expenditures that help those in need everyday * Pays the pensions of the elderly Financial innovation make our lives more predictable and less sensitive to chance. One could argue a huge amount of human progress is owed to modern-day financial institutions. Like a software system, it's extremely naive to think that complexity is a sign that a system is rotten. Finance is an art, not a science. Sometimes we make products that we don't always completely understand until later. But the vast majority of financial innovations are deeply ingrained in the good life that you get to enjoy every day.

branchless 11y ago
Allows you to get a mortgage which is a function of available credit which is near limitless and so becomes a function of your expected lifetime earnings. Times two now they lend at "household" income. Education prices are also a function of available credit that tops out at expected total salary less food/rent expenses. It's enslaving you. Unless you ride it and enslave others. Your list reads like a wide-eyed econ grad. This is not the real world. Also note the "we" in the statement. Vested interest.
Spooky23 11y ago
All of these were done 25, 50, or 100 years ago. The basis for the mortgage industry as we know it was developed during the new deal. I need some serious convincing that the effects securitization of everything has been a net win. The markets for most of this stuff are made or directly supported by the Federal government.
- 11y ago

reactor 11y ago

https://www.youtube.com/watch?v=iFDe5kUUyT0 https://www.youtube.com/watch?v=iFDe5kUUyT0 series is a good watch and will give you an idea why they "made" it complex.

icanhackit 11y ago

Animal spirits are game theory Human behavior is a large part of the complexity because we try to use things like game theory to predict how someone will act based on a confined set of conditions which totally ignore the very long game which has been playing from long in the past and will continue long in the future. There are too many factors to account for which can make an actor appear irrational given the posited conditions, however the truth is there can never be a rational actor until we map every input and interaction in someones life. This is why the idea of a rational actor is horseshit. Nick Szabo did a recent post that covers this: A small-game fallacy occurs when game theorists, economists, or others trying to apply game-theoretic or microeconomic techniques to real-world problems, posit a simple, and thus cognizable, interaction, under a very limited and precise set of rules, whereas real-world analogous situations take place within longer-term and vastly more complicated games with many more players: "the games of life". http://unenumerated.blogspot.com.au/2015/05/small-game-fallacies.html http://unenumerated.blogspot.com.au/2015/05/small-game-falla...

brownbat 11y ago

Or, some investment decisions resemble Keynesian beauty contests: https://en.wikipedia.org/wiki/Keynesian_beauty_contest https://en.wikipedia.org/wiki/Keynesian_beauty_contest

querious 11y ago

I think of it as an arms race between traders and regulators. The more complex the security, the longer it will take regulators to pass rules against its misuse, figure out taxation, etc. In the meantime, the inventor stands to make an enormous amount of money. Also, there's an inherent information asymmetry favoring the inventor.

curiousjorge 11y ago

because it attempts to quantify and model the unpredictable and lot of people are paid very well to keep that image going for as long as they can.

conductr 11y ago

Because telling the future is complex

hartator 11y ago

Taxes also had a lot to do of the complexity of the system.

rcarrigan87 11y ago

Finance is just a set of tools. Just like anything else it really comes down to the moral fiber of the individual wielding that tool. Fischer Black and Myron Scholes weren't sitting in front of their white board thinking about all the people they could rip off. They were genuinely trying to find a way to price options as a tool to mitigate risk. I can use a hammer to build a house or sink the hammer into my enemies head. Either way, it's still a hammer.

innguest 11y ago

"The study of money, above all other fields in economics, is the one in which complexity is used to disguise truth or to evade truth, not to reveal it." John Kenneth Galbraith, Money: Whence It Came, Where It Went (1975), p. 5

hiram112 11y ago

FWIW, I'm relatively quick, pick up languages (both CS and natural), frameworks, algorithms, etc. without much trouble. But I've tried again and again to understand how our basic Federal Reserve System functions - Gov't debt, banks, reserve margins, mortgage loans, etc. etc. I've NEVER gotten a basic "THIS IS HOW IT WORKS in 21 DAYS", Stack Exchange-type-answer. Lots of opinions... This itself leads me to believe that Finance is corrupt. I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs. T. Jefferson

iolothebard 11y ago
Lmao, can't understand it so it's corrupt. Sounds like all the people that think the same about IT. It's "magic". Buy and read some books, it's laid out pretty clearly. If you're not sure what to read, email some of the professors in finance at the University you went to.
- Sone7 11y ago
  I'm curious what makes you so sure you really understand it? It seems to me that when wealth is being concentrated more and more into the hands of the wealthiest all over the world, there is something deeply wrong with the financial industry and its textbooks.
  - iolothebard 11y ago
    Lol, degrees in finance and econ. Years of working in the industry as well. Why do you think people in finance aren't the ones being eaten up by increasing productivity and stagnant wages? I got out of the field because I thought IT would be more rewarding. If I had it to do over again, I'd be one of those finance assholes ripping everyone off and laughing all the way to the bank.

Animats 11y ago

"The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear." This. If you have money, and let it be known that you have money, you will be offered a large number of stupid deals. There is a huge range of financial products out there which underperform the market. Amazingly, people buy them. Wealthy people. The deals offered poor people, such as payday loans, and crap auto loans, suck even worse. Most Americans were better off when we had regulated savings and loans, tightly regulated banks, and a much narrower range of financial products.

erebus_rex 11y ago

The inherent role of finance is NOT to hide risk. Its role is to connect people who have one type of asset they no longer want with someone who does. In that way bankers are just like lawyers and accountants. You pay someone to do things you don't have the time to do (or even learn how to do) so you can focus on your job. Its division of labour at the macroeconomic level and everyone benefits from specialisation. Now, I agree that contemporary finance is bloated with opacity and that banks do benefit from this via corruption (tax code and compliance reform are needed ASAP). But its disingenuous to say that the value of finance is entirely "placebo".

kmonad 11y ago

Curiously, placebos work even if the patient knows it is a placebo. Hence http://placebobutton.com/ http://placebobutton.com/ More on topic, this article is full of red herrings and poor analogies such as the above. Why on earth would you use game theory's payoff matrices as an analogy to what could perfectly be put into words? The authors thoughts on "financial institutions buffering fear" really don't require invocation of another complex framework unless he somehow wants to derive credibility from this, which would of course be poor form.

KaiserPro 11y ago

Finance is not complex. It really isn't. if you know the right people you can find out all the information you need. However: The very foundations of Finance are built on sand What do I mean by that? Finance is built on the concept of value, or worth. "How much is this gold worth?", "how much is the client willing to pay for this service?" The concept of value and worth are subjective. They are in the eye of the beholder: If you ask a thirsty backpacker stranded in the middle of the Sahara: How much are you willing to pay for a 2 litre bottle of water? The answer, most likely is many monies & possible limbs. Now trying flogging the same water to city trader in a champagne bar. I can hear you scoffing, "Oh but that's a silly example, the backpacker was practically dead" Correct, worth is subjective. Its based on your circumstances. There are many other examples, the Turner painting in a jumble sale, the sale of a sports car when the wife becomes pregnant, etc, etc. Complex derivatives are really not complex. They are normally a "RAID" of different types of contracts. What then happens is the end user is deliberately bamboozled into not asking questions.

jackgavigan 11y ago

Finance is complex because it's basically math. And math can get very complex.

ostyn 11y ago

Definitely read "fiance". Maybe I'm just projecting.

bakhy 11y ago

This reminded me of the concept of demurrage in currency [1]. The idea was brought up to solve that exact problem. The messy system of inflationary fiat currencies won, and even though it is probably better and more practical, the demurrage would have had the advantage of making it clear what we're trying to achieve. Inflation seems to be hated by many people which, judging from their other political viewpoints, should be supportive of it... [1] https://en.wikipedia.org/wiki/Demurrage_%28currency%29 https://en.wikipedia.org/wiki/Demurrage_%28currency%29

fiatmoney 11y ago

There was a nice result a while back that the efficient market hypothesis is true IFF P=NP. http://arxiv.org/pdf/1002.2284.pdf http://arxiv.org/pdf/1002.2284.pdf

ryeguy_24 11y ago

I disagree with the main thesis here. The author states that complexity is due to opacity. This may be true in some cases but there are a number of complexities in finance that are not opaque. For example, look at all the optionality and contingent payouts in an 'Power Reverse Dual Currency' derivative. It's a really complex thing. However, the term sheets tell you everything about the transaction and the ultimate payout of the derivative (it may be 50 pages long, but it's all there). To say that all things in finance are complex because they are opaque is pretty wrong. Maybe the author is talking about a different dimension of finance (e.g. the unpredictability of human behavior, I mean sure, that's opaque, but that's not finance).