Financial Services

 [Back to Money - An Overview]

Introduction

The modern world requires an efficient and reliable financial system. We need to be able to pay for things – to move money around, both within nation states and between them. And we need a way to provide capital to people who want to start or grow a business. Beyond this, we (as in 99% of the world’s population) don’t actually need many financial services.

Most ‘financial services’ are services only in the sense that they are things you pay for: they are not services in the sense of things which are useful to the wider community.

Insurance is a worthy exception to the rule. Arguably, the futures market for real goods is beneficial to world trade. But I have yet to see a convincing argument for most of the rest. If most financial instruments were made illegal, a few people would lose most or all of their income, and almost everyone else would become a small amount richer.

Banks

We discovered in the 2008 financial crash that the banks are too large to fail. The government cannot afford to allow a bank to fail, so if it is about to fail the government will bail it out – so the banks can therefore engage in risky behaviour, knowing that success produces profit, and the cost of failure is picked up by someone else.

Modern banks do many things: some essential, some helpful and some unnecessary. These things don’t all need to be done by the same institution, and the financial system would be much more robust if they were not. Things that the banks currently do include the following.

  • Financial plumbing – the mechanisms by which money flows through society, including bank accounts, cash machines, cheques, bank transfers, direct debits and standing orders.
  • Issuing and operating credit cards.
  • Giving loans – simple, unsecured lending.
  • Giving secured loans – this is more complicated, and inevitably more intrusive for the people involved, so greater regulation is required.
  • Issuing mortgages – a step up in complexity and impact from the simple secured loans.
  • Providing cautious investment – low risk, low return, to people with a reasonable track record.
  • Some social investment – investing in things which produce social good, although this is arguably the job of the government.
  • Providing simple access to stock market trading, bonds, currencies , gilts, and the range of other government-backed investments.
  • Because they have the money, they also engage in speculation – high risk, high return lending.

The banks do not make money from providing the financial plumbing, which is how they justify making so much money from everything else they do. The financial plumbing ought to be a public utility, like water electricity and rail, which the banks pay to use. Then, with the invisible cross-subsidy removed, they can be transparent in pricing their other activities.

Stock Market

The Stock Market has changed its purpose. It was established as a way to provide capital to people who want to start or grow a business: investors give money in return for a share in the ownership and the profits.

But the vast amount of stock market trade is not undertaken with the aim of investing in a business: it is done with the aim of making money from the movements of share prices – which has little connection with underlying value, and is mostly driven by the anticipation of what other investors will do in the near future. This produces an inherently chaotic system, which is a very poor environment for people who actually want to invest in a well-run business.

There are two core problems with the current system: the massive volume of electronic trading, and the speed at which trades can be completed.

In 2018, it was estimated that about 60-75% of overall trading volume in the US equity market, European financial markets, and major Asian capital markets was generated through algorithmic trading, without human intervention; in 2019, it was 70-80% of overall trading in Japan (https://www.quantifiedstrategies.com/what-percentage-of-trading-is-algorithmic/). The numbers are increasing.

Electronic trading also leads to high frequency trading, where a low return is balanced by a high volume in a very short period of time. This significantly increases market volatility (see https://en.wikipedia.org/wiki/High-frequency_trading – worth a read). Market volatility creates risk, which enables the financial traders to create and sell products which reduce (or claim to reduce) the risk: they profit from creating the problem and then profit from partly solving it.

These electronic trades do not create value: they function as a tax imposed on the stock market by a few private companies. All the profit the market traders gain from this system is profit which would otherwise go to the people and institutions which hold shares in order to share in company ownership.

We cannot turn the clock back, but there are no plausible arguments for allowing the current system to continue unchecked. There are at least two simple possible improvements: firstly tax every trade by a very small fixed amount; and secondly, create a minimum time you have to hold a stock before you can sell it – I suspect that ten minutes would be more than sufficient to make a massive difference.

Financial Instruments

‘Financial instruments’ is the collective name for several forms of contract which can be traded: they are either ‘cash’ instruments or ‘derivative’ instruments but the term ‘cash’ is misleading – it refers to an instrument which is based on something (or some things) which has (or have) an independent value. The value of derivative instruments is much harder to determine, which makes them far more dangerous.

In theory, financial instruments are beneficial because (like insurance) they spread risk, but this is only the case if the detail of what they contain is understood, and in practice the detail is often ignored.

Imagine, in years gone by, a fleet of 100 sailing ships, each containing 1,000 crates of valuable goods. Each ship has a significant chance of going down and all its cargo being lost, but you are almost guaranteed that the majority of ships will return to port and their cargo will produce a significant profit. Owning one ship is a risky business, and you don’t have the resources to own many ships and spread the risk. What can you do?

Now imagine that, instead of owning a ship, you could own a singe crate: not much profit, but much less risk. So you buy a financial instrument containing 100 crates, or maybe 1,000. That way, despite the administrative overhead, you can still make a significant profit while reducing your risk to almost zero. That is, if the crates are – as you assume – spread between many different ships.

But what if the financial instrument you have bought contains all the crates on a single ship? Then you have the additional cost of administering the instrument, and have not reduced your risk at all. That, more or less, is what happened with the sub-prime market, leading to the 2008 financial crash.

There is, effectively, no control over financial instruments: if you can write a contract and get someone to buy it, you can start trading. We need legislation to impose some quality control over financial instruments traded on the stock market. This may be politically challenging, but it is not a difficult task. Financial instruments which cannot be understood by an ordinary educated person are inherently dangerous and should be outlawed: if they are not clearly understood, they cannot be safely operated or responsibly regulated.

 

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