The twin problems of modern finance

This post will argue that the biggest problem with modern finance lies in the twin problems of widening degree of separation of ownership from the asset, and widening of differential between value and price. Taken together, they are the recipe for financialisation of the economy, with all its consequences outlined in The Rise of Finance. 

Consider this story. Once upon a time widgets were a precious commodity, whose ownership was coveted. But there were only a few widgets going around and there was big demand to own it. Some enterprising among the original owners decided to monetise their ownership by notionally slicing a widget into small pieces and selling those pieces in the form of notional shares of the widget. This was the first degree of separation of asset and ownership. Someone physically kept the widget, even as other people partially owned the widget. 

So a widget worth $100 was sliced into ten shares of $10 each. Slowly a market emerged in trading of widget shares, where the laws of supply and demand determined the trading price. In good economic times, as disposable incomes soared, the demand for widget shares rose and the price buyers were willing to pay for the same widget share increased sharply. This price rose much higher than the cost of producing the widget itself. In due course there was a complete decoupling of the price of a share of widget from its underlying production cost or any other kind of tangible value. This was the first differentiation between value and price of the widget. 

This gave some enterprising people other ideas. Instead of directly owning a part of a widget through a share, why not create an instrument which seeks to anticipate the price of the share? This derivative instrument would draw on the expectations of the price of the underlying share. It would have no tangible value beyond shadowing and anticipating the price of the widget share. This constituted the second degree of separation of asset and ownership. The derivative holder was two degrees separated from the original widget. 

This degree of separation and the difficulties associated with forecasting the price of the widget shares meant that the price of the derivatives themselves were even more unhinged from the original value of the widget. The more uncertainty there is about something, greater the dissonance. This was the second level of differentiation between value and price of the widget. 

In due course, more enterprising people enter the market. If a widget whose underlying value was so far separated could spawn such a market, what was the need for the widget itself? One could dream up a Widgecoin, create some hype and aspiration around it, and seek to monetise its ownership. All it needed was faith and associated willingness to buy the Widgecoins. There were precedents. The central banks issued currencies whose underlying value was merely one of faith in the sovereign. In this case, the asset had no real world existence and was a figment of the collective imagination of the market. This constituted the third degree of separation of asset and ownership. The owner was owning an asset which existed only in imagination!

The Widgecoins too spawn their derivatives. In simple terms, a buyer of a Widgecoin derivative was betting on a perception (the strike terms and price of the derivative) on a perception (the Widgecoin price) in a collective faith in a non-existent asset. It was imagination cubed. It is the third level of differentiation between the value and price of the "asset". 

The problem with such degrees of separation of asset and ownership is that it distorts incentives and also obscures information. The investor has little or no idea of the real claim of the underlying asset he's holding, and therefore the real extent of his risk. An objective pricing of risk and therefore the asset becomes impossible. Any kind of rational assessment goes out of the window and value becomes sidelined in the face of an irrational but highly salient perception contest that determines the price. The value and price separate out wide and far. 

As a note, what matters here is the "degree of separation" and "widening of differential", the extents of separation and differential. Some level of separation and differential is desirable and forms the basis for finance itself. But with financialisation, the extents of separation and differential become so excessive as to cause far more damage than good. And this happens in an environment of weak regulation and pervasive information deficits, and driven by perceptions and herd mentality of investors. 

Okay, a widget does not generate any income. There is therefore a case that its price is also its value. But replace the widget with an income generating asset like a company or an infrastructure asset. Its value can be captured by discounting its future expected incomes. The story replicates just as same. I have illustrated with the example of infrastructure finance here. The differential between valuation and pricing of startups is another. These are all examples of financialisation gone rogue. 

This post has been motivated by a friend who beautifully characterised the evolution of finance in Hindu scriptural terms and through the story of rustic Chaturanan Pandey. Initially, in the Krita Yuga, Chaturanan Pandey owned a small factory. In the Treta Yuga, Pandeyji decided to separate ownership from the asset and issue shares of his factory. In due course, the Dvapara Yuga arrived when he realised that the price of those shares had little to do with the value of his factory's production. Finally, Pandeyji achieved nirvana when he realised that he could actually make money by issuing shares in the name of a fictitious factory. The Kali Yuga had arrived.