
Why is finance so complex? (2011) - mayukh
http://www.interfluidity.com/v2/2669.html
======
h8trswana8
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.

~~~
nisa
*If you life in a first world country and come from at least a lower-middle class background

You are talking about money. Not modern wall-street finance.

> huge amount of human progress is owed to modern-day financial institutions.

Like synthetic credit default swaps?

> Like a software system, it's extremely naive to think that complexity is a
> sign that a system is rotten.

Complexity that can't be coped with is rotten! The Linux kernel is quite
complex but each part of it is well understood and there are a lot mechanisms
in software to reduce complexity.

> But the vast majority of financial innovations are deeply ingrained in the
> good life that you get to enjoy every day.

Tell that to Greece people that got into the Euro because of clever CDS from
Goldman Sachs or the masses of people that are stuck in debt from their
education or credit cards.

> Sometimes we make products that we don't always completely understand until
> later.

That does not stop you from selling them and acting like you do. However
recent financial crises have shown that banks offering these products for the
most part understand them... the persons buying them don't.

> Funds the massive philanthropy expenditures that help those in need everyday

That shouldn't be needed in the first place if there wouldn't be such a huge
inequality. Philanthropy is not a good idea for a good-working society. There
are laws and a justice system that is more fair than a few far too rich
persons with a selectively good cause.

> Finance is an art, not a science.

And it should be a tool not an art. A means to an end.

~~~
7Figures2Commas
> Like synthetic credit default swaps?

If you're against CDS, you should explain why.

Like any financial product, CDS is not perfect, but it's also intellectually
dishonest to argue that it doesn't offer any benefit to society. For example,
CDS is used widely by the insurers that the parent noted help individuals
protect themselves and their property.

> Complexity that can't be coped with is rotten! The Linux kernel is quite
> complex but each part of it is well understood and there are a lot
> mechanisms in software to reduce complexity.

You apparently assume that the financial markets are too complex to be managed
but poll people on a busy street in any major city and many will probably tell
you they feel computer software is unmanageably complex too. Should we call
software rotten because some people who used it have suffered some loss as a
result?

> Tell that to Greece people that got into the Euro because of clever CDS from
> Goldman Sachs or the masses of people that are stuck in debt from their
> education or credit cards.

It takes two to tango. It would be unfair to pretend that some of the near
countless individuals and companies active in providing financial services
have not acted immorally or even illegally, but it's intellectually dishonest
to pretend that every person who has taken on more debt than he or she can
manage is a victim who was coerced into making financially imprudent
decisions.

This applies to countries too.

> However recent financial crises have shown that banks offering these
> products for the most part understand them... the persons buying them don't.

Save for Lehman, which was allowed to fail, the large banks were bailed out.
If they were as savvy as you seem to think, why did they need bailouts?

~~~
Retric
CDS are not bad but the capital reserve requirements are way to low. If
selling a CDS required a 1/3 capital reserve then they would be priced at
reasonable levels and actually be wotprth something. Instead upper mid level
employees used CDS to make a classic bet, in the worst case the company fails
so it does not really matter how much it fails therefore my average expected
downside is limited and the upside is unlimited, therefore lets go insane.

------
fsk
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
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
"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
Exactly. I think he's assuming he'll never have to pay back the principle.

~~~
britknight
(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...](http://www.brookings.edu/blogs/ben-
bernanke/posts/2015/03/31-why-interest-rates-low-secular-stagnation) [1]
[https://en.wikipedia.org/wiki/Time_value_of_money](https://en.wikipedia.org/wiki/Time_value_of_money)

~~~
dllthomas
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.

~~~
fsk
Actually, it was a bad example.

Suppose you spend $1M to produce something worth $100k. You lost $900k.

But suppose you borrowed at 0% while inflation was (to use round numbers) 10%.
After about 50 years of borrowing at 0%, your $100k is now worth more than
$1M. (I'm too lazy to use logs to figure out the exact breakeven point right
now.) You made a profit.

With 0% interest rates, your investment that destroyed $900k of value was
(eventually) profitable. If you can avoid mark-to-market accounting, you can
just borrow, wait for inflation, and eventually sell for a profit.

When interest rates are less than inflation, a capital-destroying investment
can seem profitable.

~~~
anonymoushn
So in this scenario, you either got an indefinite-term loan with a 0 interest
payment, or you took a big risk by betting that the cost of borrowing would
not increase until you could pay down the loan.

------
hiram112
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
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.

~~~
jaawn
If you think you understand the truly complex parts of finance, I would
encourage you to re-evaluate. The world economy is still in turmoil and slow
recovery because a huge amount of the experts didn't even properly understand
the "innovative finance" they were using in 2008.

I don't understand it, and I have seen countless interviews and articles from
respected economists who say there are financial products they don't totally
understand either.

To "understand" something in finance is not quite the same as other
disciplines. You can understand all the pieces and all the rules of something,
but not truly "understand" it entirely. Economics involves a lot of
sociology/psychology and difficult-to-predict human behavior. It is likely
that no one is completely aware of all of these factors when it comes to any
given financial instrument.

So, I don't think you should be laughing at someone and telling them to read
books as if this is algebra or something.

~~~
iolothebard
I understand the parts I've worked in. No one likely has a clear understanding
of 100% of finance (this actually crosses finance, accounting and economics,
as well as statistics, programming and many other disciplines).

I have degrees in Finance and Economics, I'm a software engineer and my first
job was as an Auditor for Andersen, so yeah, I've got a bit of a back ground
in the "complex parts" of finance.

All it is for the most part is a fucking shell game FYI with different
entities jumping through different nonsensical made up loopholes in tax law,
financial regulations and anything else they can do to game the system.

Lots of people understood the "innovative finance" in 2008 and prior. For
every stupid bet, there's someone on the other side. In fact, the reason we
saw almost no finance people go to prison while the government gave billions,
shows they know it far better than you give them credit.

You're right, reading a book about it is beyond most people. You have to
actually pay attention as well.

------
jerf
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.

------
slg
>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.

~~~
pessimizer
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
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".

------
pgwhalen
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.

------
icanhackit
_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-
falla...](http://unenumerated.blogspot.com.au/2015/05/small-game-
fallacies.html)

------
KaiserPro
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.

------
erebus_rex
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
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.

------
rcarrigan87
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.

------
ryeguy_24
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).

------
Animats
_" 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.

------
reactor
[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.

------
bakhy
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)

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

------
querious
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.

------
brownbat
Or, some investment decisions resemble Keynesian beauty contests:

[https://en.wikipedia.org/wiki/Keynesian_beauty_contest](https://en.wikipedia.org/wiki/Keynesian_beauty_contest)

------
fiatmoney
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)

------
johnloeber
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.

------
applecore
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
The only good innovation in the intervening century was the ATM..

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

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

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

------
conductr
Because telling the future is complex

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

------
innguest
"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

------
curiousjorge
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.

