Sunday, 21 February 2010

Swap agreements and the magic of finance

The following citations come from an interesting blog article entitled Finance As Magic which can be found here .

It's surprising that Finance exists at all. Theoretically, Finance doesn't seem possible. It's just too far-fetched to expect it to work in practice. It's just a confidence trick; it all depends on trust.

We can't all rush to the exits and exercise our options to sell at the same time. If we tried to, we would soon discover that liquidity is an illusion. The magic only works if we believe in it.

The reference to the article from which these provocative thoughts come is the excellent blog Interfluidity and this piece by Steve Waldman is well worth reading as it stimulated some thoughts of my own on the really difficult question about modern markets - why should overall or systemic liquidity be taken for granted?

I would suggest that the reason finance exists - and therefore most of the time there is sufficient liquidity for markets to function - is that deep down all human beings are, to use a quaint expression, punters. Humans are one of the few species which is not likely to end up as lunch for another species, and the predator/prey dynamics, which are a matter of real life and death for other sentient beings, have been sublimated and mystified into a battle of wits where many feel that they have a chance to outsmart the next guy in the ritualized games of trading and investment.

One of the insights from behavioral finance is that most people believe that they have above average skills and, even if they may have a gloomy view about the future of the economy/society as a whole they remain upbeat about their own futures. This is the over-confidence illusion, and along with other distinctly human foibles, allows there to be a constant stream of participants willing to play in financial markets and engage in other risk based activities. Of course, it is all based on the fallacy - at least from the point of view of the financial system as a whole - that each of the punters believes that he/she will be able to make their exit from the "game" before the crowd gets wise to the fact that liquidity can only exist at the margin and not for all. The ultimate and malign fallacy that should be the real lesson from recent financial history especially, is that the notion of macro or systemic liquidity is an oxymoron.

It is to the credit of the magicians at the investment banks who perform their conjuring tricks in the world of modern finance that they have crafted so many cunning instruments of opacity and obfuscation that they have been able to mystify and ensure the continued approval and compliance of so many supposedly sophisticated risk managers, credit rating agency analysts and policy makers - or to give them their proper description - products of a credentials based culture, who, were so intimidated at the thought of being intellectually dismissed by their peers for not seeing the wisdom of highly complex derivative instruments, became gullible punters.

To be very topical - How else can one explain, for example, how so many Brussels based technocrats could have condoned the swap agreements (is condoned the right word as it suggests they actually understood them ?) which effectively allowed basket case economies, such as Greece, to post dodgy collateral and borrow money from the ECB at more or less the same rate as the much more robust collateral supplied by the German government? This truly deserves to be called magic.

To return to the title of the article we started with, for etymologists the word magic comes from the sanskrit word Maya which not surprisingly can best be translated as illusion.

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