For the Love of Money

They had running water and other complex infrastructure in ancient Rome well before derivatives were invented I really doubt we'd be living in a barren wasteland w/o them.

There would certainly be an impact if all that stuff went away but it wouldn't be because of it's absence it would be because of the pain of unwinding it all.

It's sorta up for debate.

My understanding, which is tiny and very limited, is that you can think of the role of finance operators as "liquidity providers". They're the grease in the wheels of capitalism; by either providing access to capital (via loans, or investment) or by matching buyers with sellers.

A classical example is you're a farmer that wants to hedge the risk that your crop will fail due to random weather events or that there will be such a glut in the market that you won't be able to sell your crop profitably. So, you enter a contract to sell your crop at a fixed rate long before harvest comes along. That's a future contract, and it's a kind of derivative.

So, derivatives can be really socially useful instruments. They can act like certain kinds of insurance, or allow you to capture different dimensions of value on assets that you already own.

However, and here's where the argument comes in, it's not clear that all kinds of derivatives provide socially useful forms of gambling. The prime example here is that of the collateralized debt obligation in which huge portions of the US mortgage market got sunk into.

Mortgage backed securities are probably not in of themselves terrible ideas but the way CDOs were structured made it impossible to objectively value the risk behind the instrument. It's just not clear how a dip in the market might affect the value of your CDO tranche. It's actually an np-complete problem - https://freedom-to-tinker.com/blog/appel/intractability-fina...

Another example is high frequency trading - where you're a day trader on steroids and have computers exchanging massive quantities of stocks based on fluctuations of fractions of cents. HFT people will argue that they provide more liquidity in the market - it's easier to sell your stocks because HF traders increase the overall volume, etc. However, it's in effect launched an arms race between different trading firms and some people say that they're literally making money by skimming off everyone else who trades stocks. There's a very reasonable argument that we don't want markets to operate faster than human perception. If you have to make a decision about selling something, placing a ground foor and minimum transaction time of say half a second isn't going to harm anyone who needs that liquidity for their business, or anything else that touches the "real economy".

To summarize: certain kinds of financial instruments seem to provide no value above and beyond letting well-connected actors to place (potentially ridiculous) bets. Using your money, one way or another - whether it's your farm, the mortgage on your house, or your pension fund.

--

If we accept the above as true, we can go further on a limb and ask questions about why is the wealth that passes through financial markets so liberally redistributed to people in the industry? Some people talk about it being a function of volume, but individuals are rarely if ever liable. When do they stop providing a service, and when do they start skimming off the top?

Imagine a world where some magic firehose of money gives everyone $100k/year for free. And now suppose you have the skill of redirecting that firehose a bit, with the result that you can make one lucky person get $200k/year instead, while 11 other people get $90k/year instead of $100k/year.

Then your firehose-manipulation skills are worthless to society at large -- they reduce the net influx of money by $10k/year when you practise them -- but I bet you'd have no trouble finding someone sane and willing to pay you $50k/year to point the firehose their way.

(Of course in this exact scenario you would do better just to take the extra yourself; the real-world counterpart of the skill, though, produces gains roughly in proportion to the amount of money put in, and you can do better by persuading thousands of people to get you to point the firehose their way than by just working for yourself.)

I make no claim that the real-world finance industry is like that. But it illustrates schematically how something can be (1) of negative value to society as a whole and (2) something sane people are willing to pay for. And it's not unreasonable to conjecture that a lot of the things investment banks and hedge funds do have something like the same structure.

Oh, one other thing. Suppose that actually the firehose distributes money very unevenly. Then you might do this: manipulate the firehose to benefit one set of rich people at the expense of another, take their money, and give some of it to poor people. Doing that might be substantially net positive to society. So even taking this rather cynical view of the finance industry, some people in it might be doing a whole lot of good on balance. (It's called "earning to give" by the cool kids these days. But even if you don't explicitly give anything away, the magic of income tax -- if the government spends reasonably wisely -- may turn a slightly-negative-sum activity into something that benefits society on the whole.)

[EDITED to insert an accidentally omitted word and clarify slightly. No change in substance.]

As the above commenter stated. In the classical example (and a perfect world) derivatives can act as a sort of "insurance" or guidebook of risk. But we do not live in a perfect world. Greed is a real thing (and maybe one of the reasons Capitalism works so damn well), so it rarely works exactly that way. In the end it is often just a way to treat the little guy as a sucker while insulating the bigger fish. Or at least that is how history has shown it to play out so far.

It's not worthless - derivates have an important function in reducing volatility. But the rewards for being a merely competent derivatives trader are wildly disproportionate to the rewards for being competent in some other challenging field (eg nursing, as mentioned int he article). It's a classic example of rent-seeking.