Finance Career: Q&A for Physics PhD Seeking Advice | TwoFishQuant

[twofish-quant]

Assuming that all physicists are going into finance to cash out and are going to screw everything up is silly

And even having physicists cash out is not necessarily a bad thing. I'm hoping that a decade from now I'll have a fat bank account, and be using it to fund my own research in supernova and high performance computing. I'll also have a ton of experience in things like management, finance, and politics which I'll be able to use to do astrophysical things. Right now, "I want a moon base" is idle talk. When I have money and political connections, then I can effectively lobby for moon bases.

Ultimately, the reason I went into finance was that I want to study astrophysics. If someone has a better plan than make a ton of money from Wall Street and then cash out, I'm open to alternatives...

Now a critical part of this strategy involves not blowing up the world...

I can hope for stuff. I can pray for winning the lottery, or I can actually do something that gets me what and where I want.

Because he's talking about what "quant types" are doing now, as opposed to back in 2005:

Which is pretty relevant for someone looking to get into the business now. Now what the world looks like in 2017, I really don't know. I subscribe to the "pinball model" of history and finance. If you want to know what the world looks like tomorrow, then it's going to look a lot like what it looks like today. If you are trying to model the motion of a pinball, you can use the same principle until it hits a bumper at which point it's going to fly off in some random direction. (I did some work in chaotic billard systems.)

As time passes the odds of something happening that causes the "straight-line" approximation to fail increases until it hits one. You can deal with this sort of system using Lypanov exponents and timescales, so the time scale for "history hitting a bumper" is roughly two to three years.

Also it matters when you hit the bumper. For example, right now there really isn't that much point in talking about financial regulation, because all of the big decisions were made two years ago, and no one wants to revisit them and undo the deals that were being made.

 

[twofish-quant]

It doesn't surprise me that people would use Ising models in finance contexts, although I would expect that most economic systems are not necessarily in equilibrium and so dynamical models would have to be used to model the financial situation properly.

What ends up being useful is multiple-scale analysis...

http://en.wikipedia.org/wiki/Multiple-scale_analysis

What happens with complex dynamical systems is that you often have things happening at vastly different time scales, so what you do is to calculate a local equilibrium at one time scale and then using that as your order zero scenario to do perturbation analysis at a different scale.

So in stars, you have things happening on hydrodynamic scales (i.e. seconds) and nuclear time scales (millions of years) and then you separate those two problems.

This happens a lot in finance. The time scale for stock prices equilibrium is seconds. The time scale for macroeconomic impact is months. The time scale for institutional changes can be years or sometimes decades. So you assume local equilibrium at one level and use that as the base case for another level.

Very dramatic things can happen if something goes wildly out of local equilibrium at one level since it takes down all the levels above it. You end up with supernova and financial crashes.

One other nice thing about Ising spin models and monte carlo methods is that they are dead simple to explain to someone without any technical background. If you write a bunch of greek symbols, this will not do for a regulator or senior manager.

But it's easy to come up with an explanation of an Ising model. I have a bank, which is either alive or dead. If a bank dies then it has a probability X of causing neighboring banks to die. I run a computer simulation with these assumptions and see what happens. It turns out that if a few banks die then nothing bad happens, but I go over a threshold then suddenly all of the banks die.

And that you put that into a powerpoint and draw some pictures...

I would expect that for looking for signals of approaching crashes a non-equilibrium kind of model would be necessary. Then again, that's the sort of thing I've done in other contexts, so perhaps I'm biased in my approach (although I would still be skeptical about using equilibrium stat mech unless someone can provide good reasons as to why the system has equilibrated).

You can use local equilibrium some times. If we are talking about timescales of an hour, then stock prices are in local equilibrium. Also very interesting things happen when you get into very non-equilbrium situations because quantities that assume equilibrium become hard to define. If you look at a single electron, you really can't talk about it's entropy or temperature.

Similarly when you are looking at timescales of seconds or lower, it's difficult to define a "stock price." To have a defined "price" you have to have an equilibrium between supply and demand. If something is wildly out of equilibrium, then the concept of "price" no longer exists. This does happen with stocks at seconds. It also happens with everything else during a financial crash (or bubble), which is very bad because markets depend on the concept of "price" to make decisions.

 

[Keile]

No, the argument is that we shouldn't hold negative connotations about physicists going into finance because some of them may actually be doing important work that's useful to the economy and is hopefully helping keep things away from another crash. Assuming that all physicists are going into finance to cash out and are going to screw everything up is silly. A physicist in finance can just as well keep things from blowing up just as much as he/she can blow them up. How do you know we'd be better off if there there were no physicists in finance? How do you know that without people actively working to understand the finance system people wouldn't just be doing dumb things that would lead us to some other disaster?

Yeah but saying that they're doing something useful to the economy is pulling at straws. Finance existed before quants. We had a growing, profitable and stable financial center before quants. Then the quants came in and contributed to one of the sector's worst collapses. I've heard arguments from bankers regarding the social utility of their work and their argument is much the same nebulous nonsense as yours. They increase efficiency in the system, they say, and we should be glad Harvard graduates are doing this because the financial system is so gosh darn important. Yada yada.

We don't need some of the smartest people alive fiddling with numbers for an MBA's personal enrichment, we want them in our labs innovating and making new new scientific discoveries.

Because he's talking about what "quant types" are doing now, as opposed to back in 2005:

So you don't reject the notion quants had a part to play in the crash? Great. Let's get to solving the big problems in America, not creating more of them as a result of shameless self-interest and greed.

 

[twofish-quant]

Finance existed before quants. We had a growing, profitable and stable financial center before quants.

And you also had financial crises before quants.

Then the quants came in and contributed to one of the sector's worst collapses. I've heard arguments from bankers regarding the social utility of their work and their argument is much the same nebulous nonsense as yours. They increase efficiency in the system, they say, and we should be glad Harvard graduates are doing this because the financial system is so gosh darn important. Yada yada.

Baby and bathwaters.

Money and the internet creates a lot of problems. This doesn't mean that we should ban it.

We don't need some of the smartest people alive fiddling with numbers for an MBA's personal enrichment, we want them in our labs innovating and making new new scientific discoveries.

Fine. Are you willing to put your money were your mouth is? It all boils down to this money thing. I'll take a 50% pay cut to work on astrophysics. Heck, maybe I'll consider an 80% job cut. Do you have a job offer in hand? Do you have any ideas for me to get a job?

Now my plan is to make a ton of money and learn as much as I can about finance and politics. At some point I hope to cash out. I'll probably do astrophysics research. I'll have enough experience with this money thing and enough contacts to do things like lobby for moon bases. Heck, if I know enough rich people, I might to able to convince them to build one themselves.

So you don't reject the notion quants had a part to play in the crash? Great.

Of course I don't.

Let's get to solving the big problems in America, not creating more of them as a result of shameless self-interest and greed.

This is silly and empty politician talk. It sounds good, but it's totally meaningless. Let's "solve problems!" YEAH! Can you give me some clue as to which problems you propose to solve and how you propose to solve them?

The big problem right now is how do you avoid another finance disaster. Do you have any *specific* ideas for how to do that? More regulation? Cool. What specifically do you want to regulated? Who do you want to regulated it? How do you want it regulated?

Also, we can argue whether greed is good, but I think it's pretty irrelevant to argue this. Human are greedy. If you have a social system that *depends* on people being altrustic to people they don't know, then it's not going to work.

Also, why focus on America? This is a global system.

 

[chiro]

And you also had financial crises before quants.

We did but that's always due to the way the system is structured from the start: the quants just make it worse especially when it comes to raw speculation as opposed to real hedging which is what the point of these so called "miracle math products" were meant to be about.

Now my plan is to make a ton of money and learn as much as I can about finance and politics. At some point I hope to cash out. I'll probably do astrophysics research. I'll have enough experience with this money thing and enough contacts to do things like lobby for moon bases. Heck, if I know enough rich people, I might to able to convince them to build one themselves.

This is what it boils down to: the idea of "I'll do it as long as I have to". When you get the majority thinking that way then it causes problems and it's a form of delusional personal brainwashing.

This is silly and empty politician talk. It sounds good, but it's totally meaningless. Let's "solve problems!" YEAH! Can you give me some clue as to which problems you propose to solve and how you propose to solve them?

I agree with the sentiment of your response, but I can give you one solid thing to stop a lot of problems and it has to do with liquidity.

The amount of liquidity in the system is ridiculous. It used to be that when major purchases were made the liquidity was very low in that buying a house took a long time and even getting a loan for said house or a small business.

Today money is exchanged ridiculously quickly and more importantly, money is also exchanged in very large amounts very quickly. This is very very dangerous.

When you have this kind of environment with regards to liquidity it means that all the stuff like the panics and the runs will be a lot more chaotic.

So what's one solution, get rid of instant liquidity. With respect to hedging, proper hedging does not require a lot of liquidity: when an airline takes out an option for fuel, they pay for it, it gets delivered and they use it. They don't trade it around like a one dollar bill.

If you want to speculate, you should bear the risk of having to hold on to that particular thing for a little while. The people that do real hedging won't be affected but the speculators will think twice.

It also means that the system is harder to rig when you have proper liquidity constraints. When there are requirements about how frequently exchange can occur, it means that all these absolute pointless activities like algorithmic trading will become useless and they are useless to society.

The other thing: raise interest rates. You want capital for capitalism, then encourage people to save. When rates are at zero you discourage saving and encourage borrowing. It's irresponsible and it's just down right stupid.

Lots of people are pointing out things like this all the time including fund managers and owners, professional investors, economists and journalists who have been in the system before.

This idea of trying to eliminate and move risk is ridiculous: you just make it worse when you mix this risk-management scheme with infinite liquidity.

The thing is that when you have infinite liquidity, things are going to blow up a hell of a lot quicker and it's just a ticking time-bomb.

The truth is though that infinite liquidity and speculation is profitable for the people that do it even when it blows up other parts of the world and they don't want to stop doing it because it's easy money.

There is no reason for wash trades and many of these ridiculous insurance products for betting on outcomes like interest rates. We just found out that LIBOR was rigged. I wonder how "beneficial" this is for holders of insurance contracts on interest rates.

The big problem right now is how do you avoid another finance disaster. Do you have any *specific* ideas for how to do that? More regulation? Cool. What specifically do you want to regulated? Who do you want to regulated it? How do you want it regulated?

As I said above, the biggest thing is liquidity: there is too much of it and it's destroying things.

In terms of option contracts, you have liquidity issues regarding the frequency of exchange. We already have this for mortgages (although even this has gotten worse) so at least quants have some reference point to build on in their research as well as regulators that wanted to consider how such an approach would be executed.

General rule though is that the liquidity should be such that it discourages un-necessary speculation.

So you basically tie the frequency constraints of liquidity to the nature of asset/product, how it impacts the rest of the system. If people want to have more liquidity, then they can pay a tax that is relevant to the asset/product they are trading, the market they are in, and the value of that asset.

Also, we can argue whether greed is good, but I think it's pretty irrelevant to argue this. Human are greedy. If you have a social system that *depends* on people being altrustic to people they don't know, then it's not going to work.

Also, why focus on America? This is a global system.

Humans are greedy and this means you need to design systems that are pessimistic in the way that they don't just protect us from others but ourselves from ourselves.

The best thing we can do is to come up with something that everybody agrees on or to the best approximation thereof.

I know you challenged this statement before in another thread saying "that couldn't happen", but the point of the derivatives was to do exactly that: it was to use mathematics as a way of drawing up contracts because mathematicians and lawyers on both sides would tell their clients that everything was A-OK.

The problem is that these contracts and products only focus on two parties and you have an entire system of things go on that impacts everything.

The other thing is that a lot of the people that are affected don't really have any part in terms of a physical action in the creation and execution of these contracts which basically affects their own form of arbitrage (i.e. they have none) while the financial institutions have all the arbitrage at their disposal.

So ultimately the solution is to implement principles where all people have the same advantage and this means being really pessismistic.

The answer is going to be something that everyone hates because they can't game the system for themselves and will be politically un-palatable for everyone and this is the biggest thing that sets it back from even being considered because as you pointed out, people are greedy.

So ironically, IMO, the solution will be something that absolutely everybody hates at first, but eventually one that everybody appreciates a lot later and I only see it happening when everything goes to hell and as a consequence there is very serious discussion about what to do about it.

Until the world literally goes to hell, I can't see it happening any time soon but it has to affect the entire world so that everybody is affected in some way and although I'd rather it did not happen, I can't see any other way for it happening.

When it happens to a few people, the rest can deny it: when it happens to everyone, no one can deny it.

 

[Mute]

Yeah but saying that they're doing something useful to the economy is pulling at straws. Finance existed before quants. We had a growing, profitable and stable financial center before quants. Then the quants came in and contributed to one of the sector's worst collapses.

I seem to remember that a much worse economic collapse occurred way back in 1929, well before quantitative finance became a field. I'm sure at the time people also claimed the financial centers were growing, profitable and "stable", too. Assigning all of the blame for the recent collapse to quants and the like is at best simplistic and at worst disastrous, because if you assume that the problem was the entirely the quants, then you become blind to the other causes that might well have caused a similar collapse (better or worse) even if quants didn't exist. Your primary advantage in this argument is that it appears that the use of a financial model beyond its applicability was one of the important contributing factors to this collapse, but it doesn't prove that no collapse would have occurred without quants.

Furthermore, one of the reasons we haven't had such a disastrous collapse since the great depression is that people spent a lot of time thinking about what went wrong and instituted measures to prevent similar problems from happening again. The same sorts of things are going to happen and are happening now, and unless people can demonstrate that the financial system is going to work better without a deeper understanding of it, banks aren't going to stop hiring quants.

I've heard arguments from bankers regarding the social utility of their work and their argument is much the same nebulous nonsense as yours. They increase efficiency in the system, they say, and we should be glad Harvard graduates are doing this because the financial system is so gosh darn important. Yada yada.

How does one measure social utility? I don't know if quants actually increase efficiency in the system. I'm just putting forward the notion that maybe, just maybe, some quants are doing something that is useful, and we just don't hear about it because it doesn't impact us as obviously as the economic downturn did.

What's the social utility of a string theorist?

We don't need some of the smartest people alive fiddling with numbers for an MBA's personal enrichment, we want them in our labs innovating and making new new scientific discoveries.

Most of those "smartest people alive" also want to be in labs innovating and making new scientific discoveries, but there just aren't enough well-paying jobs to absorb them all. Why should those "smartest people alive" subject themselves to years of postdocs in which they make low salaries, have to move around the country/continent/world, in hopes of landing a permanent job at a university or lab, with limited their ability to support a family when they could go into field and have actual financial and geographical stability on a much shorter time-scale? If they can't find a decent job in the field they want or have to postpone stability in their lives for years to do it, exactly what incentive is there for the "smartest people alive" not to go into finance?

Experimentalists perhaps have an easier time finding jobs in industry. What about theorists who want to be able to keep using the skills they've learned but no longer want to be in academia? Would you prefer they all got jobs modelling for the gas and oil industry? Is that a morally higher ground than finance? Who's willing to hire theoretical physicists to do theoretical physics? If you have a serious answer to that question, I'd certainly like to hear it! I'm 100% serious! I'd certainly love to keep doing science my whole life, but if it's going to take me another 3-6 or more years to get a tenure-track position and actually start settling down, and then another five years on top of that to get tenure, then yes, I am going to look at other options, and those options are going to include finance. (And I'd like to think that I would be one of the people trying very hard to not let the system collapse!)

So you don't reject the notion quants had a part to play in the crash? Great. Let's get to solving the big problems in America, not creating more of them as a result of shameless self-interest and greed.

I also don't reject the notion that physicists had a part to play in developing the nuclear bomb, which brought the world to the brink of destruction during the Cold War (and still threatens to do so, although tensions are seemingly not quite as high as back then). Do you think you would have suggested at the time that people should stop doing physics just because some physicists had made such a destructive weapon?

I don't see why quantitative scientists should stop doing finance just because some quants made a model that was used beyond its realm of application and played a role in the recent economic collapse. It doesn't mean all quants are going to screw up the system, and it certainly doesn't mean it's not possible for a quant to do something that will help prevent economic collapse rather than cause one.

So, Keile, what exactly is your expertise on the subject, and how have you come to the conclusion that no quants are able to do anything useful in finance? (This is not a rhetorical question)

As for my expertise, to save you the trouble of asking, I am not an expert on financial systems themselves, but much of my graduate research has been studying models of other systems which exhibit kinds of catastrophic failures and trying to devise signals or methods of predicting those collapses. This has obvious connections to the concept of trying to predict economic collapses in financial models and systems, hence my interest in the current discussion.

 

[twofish-quant]

I seem to remember that a much worse economic collapse occurred way back in 1929, well before quantitative finance became a field.

You also had major economic messes in 1973, 1980, 1985, 1989, 1997, and 2001. Now, 2007 was unusually because it was global, but I would argue that the cause of that is the internet. You can move money and ideas across the world in milliseconds. That's mostly a good thing, but it does have drawbacks.

Assigning all of the blame for the recent collapse to quants and the like is at best simplistic and at worst disastrous

There's a very fine line between "accepting responsibility" and "being a scapegoat." As part of the financial system, physics Ph.D.'s do have some blame for what happened, but I don't think that physicists were the sole or even the most important piece of the problem.

Your primary advantage in this argument is that it appears that the use of a financial model beyond its applicability was one of the important contributing factors to this collapse, but it doesn't prove that no collapse would have occurred without quants.

There's one particular equation that blew up the world. The Gaussian coupla model for collaterialized default obligations. The problem was that that model and cheap computers made lots of people very wealthy, so by the time the physics geeks were starting to warn people about the limits of that equation, they were brushed aside in a lot of places.

The basic problem is that in 2004, if you were a physics Ph.D. that was in a badly run firm, then people would just not listen to you. You're only choice was to move to a firm where your opinions were respected. Now from a "personal morality" point of view, that was a good thing. From a social system point of view it led to a "reverse Darwin" effect. Clueless firms became more clueless, until the system blew up at its weakest links.

Now people have tried to fix the problem. Today, if you come up with a model, then dozens of people are going to look over it before it makes it anywhere near real money, and there are lots of places where people can veto moving the model to production. That means that banking is extremely bureaucratic with a ton of procedures. But that also means lots of jobs for people that can understand high level mathematics.

The same sorts of things are going to happen and are happening now, and unless people can demonstrate that the financial system is going to work better without a deeper understanding of it, banks aren't going to stop hiring quants.

There have been a lot of important decisions made, and the people have more or less agreed on the regulatory framework. The big thing that is going on right now is implementation of the Basel III standards.

http://en.wikipedia.org/wiki/Basel_III

There are a *lot* of interesting physics-type problems here.

How does one measure social utility? I don't know if quants actually increase efficiency in the system. I'm just putting forward the notion that maybe, just maybe, some quants are doing something that is useful, and we just don't hear about it because it doesn't impact us as obviously as the economic downturn did.

And then there is the social utility of keeping physicists doing hard math. I spend most of my days solving very hard math and computer problems. It keeps my brain going. If aliens suddenly invaded and the world needed scientists to design laser cannon flying saucers, I'm ready, because I've been doing enough math so that I can switch to something else.

Now if I was working at a non-math job, there would be nothing to keep my skills from rotting. So even at the level of "storing brain power", Wall Street is performing a useful service.

I'd personally be glad if there were other types of jobs available for theory Ph.D.'s. But nothing is stopping people from talking about other types of jobs here.

Most of those "smartest people alive" also want to be in labs innovating and making new scientific discoveries, but there just aren't enough well-paying jobs to absorb them all.

And the cool thing is that I am innovating. One thing about academia is that people care about credit. I don't care about credit as long as I can get cash. We use several open source packages where I work, and we've been very, very active at pushing our improvements back into the software community.

If they can't find a decent job in the field they want or have to postpone stability in their lives for years to do it, exactly what incentive is there for the "smartest people alive" not to go into finance?

And then what happens when your lottery tickets don't pay off?

Would you prefer they all got jobs modelling for the gas and oil industry?

Done that too. :-) :-) Not a bad job, and I'd still be happily employed in an oil company had we not gotten an idiot CEO that decided to fire everyone.

I also don't reject the notion that physicists had a part to play in developing the nuclear bomb

And that's the third major employer of astrophysicists. Building hydrogen bombs. I know people that do that. I respect them. It's not a good job for me. My problem is that I talk too much. That's a mildly negative thing when you work in finance. Talking too much can get you in jail if you build H-bombs. The worst thing my current employer can do to me is to fire me, and if they do, they aren't going to be following me for the rest of my life. Once you get hired building nuclear weapons, people *WILL* be tracking you for the rest of your life.

The big three employers of astrophysicists are oil gas, finance, and nuclear bombs. You might wonder why astrophysicists get hired studying things that could wreck the planet. Not a coincidence. Once thing that you quickly figure out when you do astrophysics is how puny and fragile the Earth is in comparison to the rest of the universe. Once you start studying planet-destroying energies, it's not a surprise when you get hired in areas that could blow up the planet.

As for my expertise, to save you the trouble of asking, I am not an expert on financial systems themselves, but much of my graduate research has been studying models of other systems which exhibit kinds of catastrophic failures and trying to devise signals or methods of predicting those collapses.

I'm not an expert in financial systems either. I've been working in finance for five years. Even if I spend the next thirty years working on this, I won't be an expert.

 

[twofish-quant]

So what's one solution, get rid of instant liquidity.

Fine, how do you propose to uninvent the internet? Money today consists of electronic pulses that can travel at pretty close to the speed of light. You have instant liquidity because you can money electrons very, very quickly.

When there are requirements about how frequently exchange can occur, it means that all these absolute pointless activities like algorithmic trading will become useless and they are useless to society.

Ever hear of Las Vegas? Las Vegas gets it's wealth because casino gambling is prohibited in most of the United States. So the one place where it isn't makes tons of money. This is a very common theme. There are several small islands in the Caribbean that have entire economies devoted to circumventing regulations.

If you institute draconian regulations everyone except the South Pole, someone will set up a financial center in the South Pole and thanks to the internet, you can do all your transactions there.

The thing is that when you have infinite liquidity, things are going to blow up a hell of a lot quicker and it's just a ticking time-bomb.

Exactly. So how do you propose to uninvent the internet?

So you basically tie the frequency constraints of liquidity to the nature of asset/product, how it impacts the rest of the system. If people want to have more liquidity, then they can pay a tax that is relevant to the asset/product they are trading, the market they are in, and the value of that asset.

At which point people will just move their money to places without that tax and do the deal there. Press a button. My money just went to the British Virgin Islands. Press another button. We just did the trade there. This internet thing makes things annoying.

 

[StatGuy2000]

There's one particular equation that blew up the world. The Gaussian coupla model for collaterialized default obligations. The problem was that that model and cheap computers made lots of people very wealthy, so by the time the physics geeks were starting to warn people about the limits of that equation, they were brushed aside in a lot of places.

The basic problem is that in 2004, if you were a physics Ph.D. that was in a badly run firm, then people would just not listen to you. You're only choice was to move to a firm where your opinions were respected. Now from a "personal morality" point of view, that was a good thing. From a social system point of view it led to a "reverse Darwin" effect. Clueless firms became more clueless, until the system blew up at its weakest links.

Now people have tried to fix the problem. Today, if you come up with a model, then dozens of people are going to look over it before it makes it anywhere near real money, and there are lots of places where people can veto moving the model to production. That means that banking is extremely bureaucratic with a ton of procedures. But that also means lots of jobs for people that can understand high level mathematics.



There have been a lot of important decisions made, and the people have more or less agreed on the regulatory framework. The big thing that is going on right now is implementation of the Basel III standards.

http://en.wikipedia.org/wiki/Basel_III

There are a *lot* of interesting physics-type problems here.

Here are some questions for you, twofish-quant.

(1) You had stated above that back in 2004 if you were a physics PhD (or math, statistics, or operations research PhD) working as a quant in a badly run firm, people would not listen to you. How many of the major financial firms operating in the world today are well-run now, in the sense that those with the expertise are listened to?

I ask this because the math/physics/stats PhDs have been made to be the scapegoats in the financial crash of 2007, but I personally feel that the poor use or misuse of mathematical models in financial instruments is as much, if not more, of a result of poor decision-making on the part of upper management who had no understanding or appreciation of the limitations of those models and either foolishly trusted the models or refused to listen to those who questioned them.

(2) Do you feel that the full implementation of Basel III standards is sufficient in mitigating or greatly reducing the risks of the banking crashes and the contagion effects that we've seen occur in 2007? If not, what else do you feel needs to be done?

(3) On a related note to point (2), you had stated earlier that if we build too draconian a system of regulations, then financial firms will have incentives to simply move to another part of the globe where such regulations are lax. This would just as likely put efforts at Basel III to nought as well. After all, Basel III are a voluntary set of standards; the Feds can mandate enforcement within the US or with dealings with US institutions, but they cannot enforce it on firms with key operations out of the US. Ditto for other firms. Not to mention that there are still questions on how Basel III can be implemented with insurance or hedge funds.

 

[chiro]

Fine, how do you propose to uninvent the internet? Money today consists of electronic pulses that can travel at pretty close to the speed of light. You have instant liquidity because you can money electrons very, very quickly.

The internet is a general device for communication and while I agree that it facilitates all the exchanges that are made, it doesn't control them.

There are already bodies that are meant to regulate the exchange and are in charge of their own portion of regulations and these are the banks and the regulators themselves.

Credit for a start is a regulated entity and these so called Caribbean islands don't create a lot of credit. The main problem is not moving around non-credit forms of digital "wealth" like savings, but stuff that has more to do with speculation and that is centred on credit.

When deposits are moved around at the speed of light, then everybody who does that should have the right to do so. The deposits came largely from both labour and existing credit and that's not the problem.

The problem comes in at the point where credit is created, and credit comes from the top to the bottom: from the central banks down to the consumer/business lending banks and they can and should have regulated liquidity constraints.

When people speculate, a lot of the time they are doing it with credit and not with deposits or savings. If someone goes to Los Vegas and blows their weekly wage then that's OK. When someone however blows 50,000 of money of which they only have 500 (i.e. a leveraged bet of 1:100) then that creates a systemic problem for the casino, the person and a whole chain of other people. Again, the point has to do with credit.

If you are speculating and the speculation is based on credit, the creditor can enforce the regulations at the point of credit creation. If the speculator is using their own deposits that are not bound to credit, then the liquidity should be infinite as they are only affecting themselves: it's their money and there are no chances for cascading effects like defaults and the like.

Credit creators have always done this: you get a business loan for a bank, they might stipulate conditions for you to get the credit.

So to summarize, you enforce at the point of credit creation and it's use in regard to what the credit is used for. We already do this kind of thing in some ways, but the practices and policies need to be updated for all these new uses for derivative products and the like.

Ever hear of Las Vegas? Las Vegas gets it's wealth because casino gambling is prohibited in most of the United States. So the one place where it isn't makes tons of money. This is a very common theme. There are several small islands in the Caribbean that have entire economies devoted to circumventing regulations.

Again, the main issue has to do with credit creation: this is the entry point for liquidity and it's only logical that this is the point where you start with the new regulation.

Carribean islands aren't major creditors and most of the large creditor nations are ones with large economies that include high productive capacities and not just ones that are largely tax havens and tourist economies, and that's for a very good reason.

If you institute draconian regulations everyone except the South Pole, someone will set up a financial center in the South Pole and thanks to the internet, you can do all your transactions there.

It's not so much the transaction aspect, again it's the credit creation.

The issue of credit vs capital is the big thing and they are very different even though some people see them as the same: they're not.

When one creditor gets a bad reputation, people stop going to that creditor and they end up going to another. Creditors have every reason to keep their reputation at the highest standard, and doing something like this would encourage investment in an economy because it demonstrates sound policies for aiding an economy over destroying it.

The problem is not the internet, it's the aspect of credit creation and how this credit creation indirectly facilitates these problems of instant liquidity in the context of speculation.

Exactly. So how do you propose to uninvent the internet?



At which point people will just move their money to places without that tax and do the deal there. Press a button. My money just went to the British Virgin Islands. Press another button. We just did the trade there. This internet thing makes things annoying.[/QUOTE]

 

[twofish-quant]

(1) You had stated above that back in 2004 if you were a physics PhD (or math, statistics, or operations research PhD) working as a quant in a badly run firm, people would not listen to you. How many of the major financial firms operating in the world today are well-run now, in the sense that those with the expertise are listened to?

"Well run" as in that sense, I think that all of the major banks are. The thing is that the regulations have changed so that you cannot ignore quantitative views, and the major governments have forced the larger banks to make changes so that you have to go through risk controls to do anything. There's also been a major cultural shift. Before 2007, it was the traders that ran the company because they were closer to the money. Now, it's the risk managers, because they are closer to the regulators.

Now, this may not prevent another crash. Financial systems being as complex as they are it's possible that something that no one in the industry is seeing will lead to another blow up, but if the system blows up, it will be for reasons which are not obvious now.

I personally feel that the poor use or misuse of mathematical models in financial instruments is as much, if not more, of a result of poor decision-making on the part of upper management who had no understanding or appreciation of the limitations of those models and either foolishly trusted the models or refused to listen to those who questioned them.

1) This is why people with mathematical skills get into relatively senior management positions in finance.

2) It's not so much of understanding than psychology. If an equation is making you personally wealthy then you are not going to be intentionally looking for flaws in that equation. If you think that there *may be* a flaw, you aren't going to be spending that much effort to make sure.

(2) Do you feel that the full implementation of Basel III standards is sufficient in mitigating or greatly reducing the risks of the banking crashes and the contagion effects that we've seen occur in 2007? If not, what else do you feel needs to be done?

I don't know. Part of the question right now is that Basel III is more of a *process* than a set of firm standards, and part of the process involves some basic mathematical research. For example, Basel III contains standards on liquidity. Well how do you measure liquidity? What is a price? Mark-to-market? Which market?

Just from general principles, I can't say that something bad won't happen. Also I can say pretty confidently, that we won't see something exactly like 2007, because history just doesn't repeat. But as far as getting us into a situation where we end up doing something that causes worse problems, I don't know. Not knowing is fine. Thinking that you know when you don't is dangerous.

One of the reason this is a real problem is that there are reasons to think that Basel II actually made the financial crisis worse. The idea was behind Basel II was that you could use as bank reserves products that hedged your positions, which meant that European banks bought tons of derivatives to hedge their losses, so that in a crisis they would be protected against losses by their derivatives... Oooopppppsssssss...

So it's very possible that we are doing something right now that will dig the hole deeper. Or not.

If people really knew what was going on, they wouldn't need to hire researchers.

This would just as likely put efforts at Basel III to nought as well.

It makes life much more difficult, but all of the governments think that "blowing up the world" is a bad thing. There's a minimal set of things that the all of the major powers agree on, and that's enough to limit regulatory arbitrage. Again Basel III is a process, so that when people do disagree over some things, people can scream at each other and come up some agreement rather than to just let things collapse.

The idea of "blowing up the world is a bad thing" is something that we can get agreement on. The idea that "gambling and speculation is a moral sin that ought to be banned" is something that you can't. People in the UK just don't believe this, and that impacts the financial system. It is *extremely* difficult to buy and sell retail derivatives in the US. Trivially easy in the UK. The idea that "banks shouldn't run companies" is something that Americans believe, but not the French or the Germans.

One other thing which I think is a real problem but it's a reality is that the people that go to the meetings in Basel share a pretty common world view. They all know each other, and their kids all go to Harvard or Yale. The richer and more powerful you are, the more global you are, and there is something of a new "planetary elite." It's something that I find a little disturbing.

After all, Basel III are a voluntary set of standards; the Feds can mandate enforcement within the US or with dealings with US institutions, but they cannot enforce it on firms with key operations out of the US.

Basel III is "voluntary" in the same sense that filling out your income taxes in the US are "voluntary."

Feds mandate enforcement in the US. FSA for UK. CBRC for China. All the regulators talk to each other, so if the Fed tells you to do something at a meeting, it's very likely that the FSA will tell you to do the same thing at the next meeting. If the Fed and the FSA disagree about something, it's likely they'll work it out before they talk to you.

Ditto for other firms. Not to mention that there are still questions on how Basel III can be implemented with insurance or hedge funds.

People figured out a regulatory system for hedge funds after LTCM, and that worked pretty well in 2007. The thing is that you don't regulate hedge funds. You regulate the banks lending money to hedge funds. Hedge funds blow up all the time. Since LTCM, that hasn't caused a domino effect because what happens is that the bank killed the hedge fund before it has a chance to be de-stabilizing.

 

[twofish-quant]

There are already bodies that are meant to regulate the exchange and are in charge of their own portion of regulations and these are the banks and the regulators themselves.

And those bodies proved ineffective in 2007 which is one reason that the crash happened. One big problem was that government bureaucracies move very slowly, and they were outrun by technology.

The problem comes in at the point where credit is created, and credit comes from the top to the bottom: from the central banks down to the consumer/business lending banks and they can and should have regulated liquidity constraints.

And they do. The trouble is that with the internet you can work around the liquidity constraints. Let's talk about interest rates. If you go to a US commercial bank you'll find that their interest rates for saving are lower than a money market account you can get through a broker.

Why is that? Well, US commercial banks are required to hold reserves. Money market funds are not. MM therefore can offer much better rates than banks. This didn't matter in 1950, but now with the magic of the internet, I can log into my online broker and they have a nice web page listing all of the various funds with their interest rates.

If you pick up an economics textbook that talks about the banking system, it's likely very, very wrong. There's this thing called the "shadow banking" system. What people don't realize is that the "shadow banking" system *is* the banking system.

When people speculate, a lot of the time they are doing it with credit and not with deposits or savings.

Everything is credit. What's a savings account? It's credit that you are providing to the bank. One big problem in explaining money is that people think of money as a "thing" like a pile of gold. When you have a "deposit" in a bank, it's not that the bank has a pile of gold. It's not that there is *anything physical at all*. When you deposit something into a bank, you have just provided the bank with a callable loan.

So to summarize, you enforce at the point of credit creation and it's use in regard to what the credit is used for. We already do this kind of thing in some ways, but the practices and policies need to be updated for all these new uses for derivative products and the like.

Again, the main issue has to do with credit creation: this is the entry point for liquidity and it's only logical that this is the point where you start with the new regulation.

There is no such point.

When one creditor gets a bad reputation, people stop going to that creditor and they end up going to another.

I take my paycheck and deposit it into the bank. I am now a creditor to the bank who is now a debtor to me. The bank doesn't care what my credit rating is.

I feel as feel as if I'm trying to explain the big bang to a young Earth creationist. The basic problem with your view is that

1) you *cannot* have a hedger without a speculator, and
2) you *cannot* have a creditor without a debtor

When I deposit money into a bank, I'm creating credit. I'm the creditor and the bank is a debtor. When the bank loans out the money (and sometimes they'll loan it back to me) the arrow is reversed.

The thing about banks is that they *are not* net creditors. Banks just transmit credit from the depositors to loaners while taking a bit of transaction fee on the side.

 

[chiro]

And those bodies proved ineffective in 2007 which is one reason that the crash happened. One big problem was that government bureaucracies move very slowly, and they were outrun by technology.

There was a lot of stuff that proceeded this like the removal of Glass Steagal that was introduced after the great depression happened and it was introduced for a reason.

And they do. The trouble is that with the internet you can work around the liquidity constraints. Let's talk about interest rates. If you go to a US commercial bank you'll find that their interest rates for saving are lower than a money market account you can get through a broker.

The issue is the regulation of credit creatioh policies system-wide and this is not about competition for people's deposits.

Credit creation is the same in principle whether a central bank does it or whether a small lending facility does it.

Why is that? Well, US commercial banks are required to hold reserves. Money market funds are not. MM therefore can offer much better rates than banks. This didn't matter in 1950, but now with the magic of the internet, I can log into my online broker and they have a nice web page listing all of the various funds with their interest rates.

Again, the point is not about a particular entity, but rather a general approach to credit creation.

There already are regulations for general credit creation, but unforunately they are not uniform. Uniformity as a general regulation policy is the best policy because its simple and because it's a lot easier to understand than having a bunch of exceptions and new bills having to be passed to "patch things up".

The other thing with beauracracy is that they have so many pieces of law that they have to follow: the amount of things signed into law is absolutely ridiculous and one of the reasons why these administrators are so slow is because they are occupied with the ridiculous amount of new legislation that keeps coming in.

The idea of just "patching things up" continually in an admistrative sense is creating the very thing that it tried to prevent by having a ridiculous amount of legislation which means that it becomes a lot harder to enforce said legislation if someone ever actually wants to enforce it.

This is one primary argument for keeping things simple in a legal sense and not just a financial sense.

If you pick up an economics textbook that talks about the banking system, it's likely very, very wrong. There's this thing called the "shadow banking" system. What people don't realize is that the "shadow banking" system *is* the banking system.

I am aware of this system and it's very concerning that we have "two systems".

Everything is credit. What's a savings account? It's credit that you are providing to the bank. One big problem in explaining money is that people think of money as a "thing" like a pile of gold. When you have a "deposit" in a bank, it's not that the bank has a pile of gold. It's not that there is *anything physical at all*. When you deposit something into a bank, you have just provided the bank with a callable loan.

Not everything is credit: you have for example collateral and you have credit.

Collateral is something that the owner possesses without any kind of contractual obligation to any other party.

If you own a factory out-right that is collateral. If you own a few gold bars outright that is collateral.

Credit (real credit) is anything whereby a contractual obligation exists between two parties creating obligations with regards to the ownership and the issues of how this ownership is mitigated between the two parties.

These are very distinct things and they are not the same.

In the case of a deposit, I agree that you become a creditor with the actual bank since a dependency is created, but this need not be created and something can be classed as a non-credit item in the case that wealth is stored electronically without any kind of contractual obligation regarding issues of ownership between two distinct parties under distinct rules for the creditor and the debtor.

Credit can be separated legally from non-credit.

So to summarize, you enforce at the point of credit creation and it's use in regard to what the credit is used for. We already do this kind of thing in some ways, but the practices and policies need to be updated for all these new uses for derivative products and the like.

This is the main point I am trying to make yes.

There is no such point.

The point regarding liquidity is that you treat the liquidity of credit products differently to those of non-credit products.

This would mean offering an option to people with deposits to not enter into an actual creditor contract with their lending facility. I know there are banks that do this where it really is just "administrative handling of money" without having interest rates and so on, but the holder does have to pay transaction and a small management fee for the service.

If people do not wish to enter into such a situation and want the interest (as well as what comes with being a creditor) than that is their business, but the option should be made available for people to have.

Treating the liquidity of non-credit vs credit would have a huge impact on the infrastructure and the confidence of the system overall, and the main thing about the system that everybody wants is some kind of real trust.

I take my paycheck and deposit it into the bank. I am now a creditor to the bank who is now a debtor to me. The bank doesn't care what my credit rating is.

They should: haven't we already learned our lesson here with the GFC? A credit agreement is a two process and not a unidirectional one.

I feel as feel as if I'm trying to explain the big bang to a young Earth creationist. The basic problem with your view is that

1) you *cannot* have a hedger without a speculator, and
2) you *cannot* have a creditor without a debtor

When I deposit money into a bank, I'm creating credit. I'm the creditor and the bank is a debtor. When the bank loans out the money (and sometimes they'll loan it back to me) the arrow is reversed.

Maybe my terminology was wrong but what I'm talking about relates more or less to a futures contract in opposition to an exotic derivative. Hopefully that clears things up.

Again, the issue is of resolving what credit is and what non-credit is. Collateral is not credit: there is a very clear distinction.

There needs to be a real distinction between the two and the public needs to be able to differentiate between the two as well.

The thing is however that all money in circulation is credit, but collateral does actually exist and hopefully I have pointed a few examples.

If people want to use instruments of credit, enter into credit agreements, and so on then that's OK: just regulate it differently to ones of non-credit.

The thing about banks is that they *are not* net creditors. Banks just transmit credit from the depositors to loaners while taking a bit of transaction fee on the side.

Yes I know this, and they are allowed to loan out a lot more than they have on the books through fractional reserve banking and the capital requirements issued by things like the Basel committee and other relevant regulatory frameworks.

Most people are not aware that non-credit instruments exist: they do exist but not in the form of conventional currencies whether digital or on paper.

I'm not saying to remove credit: if people want to go into credit arrangements then that is their business. If people just want to use non-credit instruments though that are not bound to distributed ownership in the form of a credit agreement that is legally binding, then they should have that option as well.

They won't earn interest and they will have to pay for the privilege for someone to administer their account and handle the transactions and all the rest, but they will have completely different liquidity constraints (i.e. they won't have any) in comparison and contrast to those bound up in crediting agreements.

 

[twofish-quant]

There was a lot of stuff that proceeded this like the removal of Glass Steagal that was introduced after the great depression happened and it was introduced for a reason.

The main reason that Glass-Steagal was repealed was again indirectly related to the
internet. US banks found it difficult to compete with European banks which did not (and
have never had) these sorts of restrictions. Once you have an international banking
system, it became very difficult to argue how Glass-Stegall restrictions were useful since
US banks could just work through foreign banks to circumvent them.

Personally, I think that abolishing Glass-Steagall actually prevented the crisis from being worse that it was. What happened was that it put some of the investment banks under commercial banking supervision, and that avoided some of the worst abuses.

Credit creation is the same in principle whether a central bank does it or whether a small lending facility does it.

Or whether you do it. I take some cash. If I use deposit it into the bank via an ATM rather than spend it, I've just created credit.

Not everything is credit: you have for example collateral and you have credit.

Collateral is something that the owner possesses without any kind of contractual obligation to any other party.

Read up on rehypothecation. If you provide collateral to a bank, they can reloan that money out. This caused a lot of problems in the crisis, when people that *thought* that they didn't have exposure to a collapsing bank did. You give collateral to bank X, bank X reloans to bank Y, bank Y collapse. You have a big problem if you want your money back.

Rehypothecation is legal in some places. Illegal in others, but guess were most loans were issued. :-) :-) :-)

Now you *can* ask for a non-rehypothecatable loan. However, the bank will charge you more for that loan. How much more? Well, let's ask this physics Ph.D. to come up with a model for figuring that out.

In the case of a deposit, I agree that you become a creditor with the actual bank since a dependency is created, but this need not be created and something can be classed as a non-credit item in the case that wealth is stored electronically without any kind of contractual obligation regarding issues of ownership between two distinct parties under distinct rules for the creditor and the debtor.

1) No it can't. When I deposit money in a bank, I expect to get it back. If there is no contractual obligation, then if I hand money over to a bank, then they can keep it.

2) If you are going to be inventing your own contract laws and definitions, this is going to
quickly become a useless conversation. Trying to invent contract and banking law is like
trying to invent laws of physics. There are specific financial definitions for terms like credit,
collateral, and contracts, and if you are going to invent your own, then this conversation
is going to get both confusing and pointless.

This would mean offering an option to people with deposits to not enter into an actual creditor contract with their lending facility. I know there are banks that do this where it really is just "administrative handling of money" without having interest rates and so on, but the holder does have to pay transaction and a small management fee for the service.

And if the bank is legally obligated to hand you your money back if you ask for it, then
you've just created a credit transaction. Now you *can* structure the contract so that
the bank cannot loan your money out, but that again is a credit transaction.

No creditor contract -> The bank doesn't have to hand you back your money.

Maybe my terminology was wrong but what I'm talking about relates more or less to a futures contract in opposition to an exotic derivative. Hopefully that clears things up.

No it doesn't.

Again, the issue is of resolving what credit is and what non-credit is. Collateral is not credit: there is a very clear distinction.

No there isn't. If the bank holds your assets as collateral, in most situations they can loan this out. They can do this because you let them in the loan agreement. Most people (even professionals) don't bother to read their loan agreements, but the standard loan agreement allows the bank to loan out your collateral.

Again, if you want to invent your own banking law, this is going to be a pointless discussion.

They won't earn interest and they will have to pay for the privilege for someone to administer their account and handle the transactions and all the rest, but they will have completely different liquidity constraints (i.e. they won't have any) in comparison and contrast to those bound up in crediting agreements.

But it's still credit. You hand money to a cash storage agency. If you expect to have that money back, then you've entered into a credit agreement. Also unless that cash storage agency stores that stuff in gold bars or paper assets, you are still exposed to the financial system. The millisecond the agency deposits those assets into a bank, then you are now exposed.

Also storing stuff in gold bars or paper assets has it's risks to. Suppose you store something in paper money, they put it into a warehouse and it burns down?

 

[twofish-quant]

The discussion of collateral is interesting because much of the current quant work involves collateral agreements.

http://arxiv.org/abs/1101.3926
http://arxiv.org/abs/1111.1331

Also

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=584102

 

[chiro]

I don't want to invent new jargon and I'm not familiar with all the jargon that exists.

I'm going to read up on rehypothecation (thanks for the heads up).

I've taken a look at the wiki page, and it is a good description of what I'm talking about with a slight difference (for the wiki page hypothecation).

The concept that I'm trying to get at is more of a thing where you give a bank some kind of collateral and the agreement you have is that you pay the bank some kind of fee to retain the collateral and engage in transactions where the collateral itself is not used in credit creation, but only in the context of exchange of something else that is a non-credit "thing".

So as an example: I pledge my collateral to a bank and I have to pay them a fee to manage that collateral and more fees to be able to transact that collateral in a manner that is not a credit transaction like a bank would normally do. There is a premium for doing this of course.

The agreement asks for all fees upfront whether they include management costs and transaction costs (they could be used by part of the value of the collateral itself, and both parties would probably prefer that).

If you miss a payment, the bank says "Sorry I'm not holding it for you anymore, here it is back" and then it becomes your problem to manage the collateral.

Basically there is no "loan" made: you have to pay the bank to manage the collateral and to make transactions which means it's a negative interest situation in a sense, but these kinds of transactions are very different from the kind of one that a bank practices which is to take deposits and loan them out giving you some of the interest.

In the above kinds of transactions there should be no liquidity constraint for any transaction whatsoever: it should be completely liquid. The constraint should come when the credit issue comes in.

I realize that a lot of people would laugh at the fact that you pay someone to manage their collateral and pay them when you ask them to transact (i.e. do real liquidation of said collateral with another party in a non-credit form), but people should have the option to do so.

It's probably not going to be a popular option anyway, but I'd imagine there would be a few people out there that would like such an option to exist to them.

I don't think this exists though for the masses given the infrastructure of the financial system and given that the whole thing is based on credit anyway, but I'd be interested to hear your take on it.

I've also thought about situation with respect to the global nature and my new take on it is this:

If people have the option of being able to access banks that can connect to the rest of the system whereby you pledge collateral to that holding facility who is regulated (i.e. has licensure and follows appropriate regulation) who can make transactions of a non-credit nature (i.e. direct one to one exchange of collateral for something else that is not a credit instrument), then that would be all.

In hindsight, it might be best for the credit system to run as it is and let people risk whatever they want to risk which means no new requirements other than the possibility for people to have access to a non-lending facility like the one mentioned above.

At least that way, the people that use this service will retain their collateral when SHTF even if they have to pay a premium to have it looked after and involved in non-credit transactions.

So yeah in short: give the public an option to put forth some kind of collateral instrument (like gold or silver), pay to have it managed (or some of the collateral may be eaten up in management fees), pay to have it transacted with other entities who run in a completely credit driven environment, and have the situation where you have to pay up front for management and transaction costs. You get the collateral back if you miss a management repayment and it's up to you.

So this is a lot simpler without any real restructuring of what already exists.

 

[twofish-quant]

The concept that I'm trying to get at is more of a thing where you give a bank some kind of collateral and the agreement you have is that you pay the bank some kind of fee to retain the collateral and engage in transactions where the collateral itself is not used in credit creation, but only in the context of exchange of something else that is a non-credit "thing".

At which point you have a secured loan or mortgage. You give the bank collateral. The bank deposits cash into your account, you can then exchange that cash with anything you want. You pay the bank a fee (lets call it "interest") and the bank makes money from that.

I realize that a lot of people would laugh at the fact that you pay someone to manage their collateral and pay them when you ask them to transact (i.e. do real liquidation of said collateral with another party in a non-credit form), but people should have the option to do so.

And they do. You can go to a bank with a house, the bank will give you cash. The fact that it was ridiculously easy to convert houses into cash was what caused this problem in the first place.

Now you could argue that that cash step is unnecessary. The bank should be able to take your house and then sell a fraction of it. The trouble is that if you buy burgers from me, I don't want 0.0005% ownership of your house. I want cash.

So yeah in short: give the public an option to put forth some kind of collateral instrument (like gold or silver), pay to have it managed (or some of the collateral may be eaten up in management fees), pay to have it transacted with other entities who run in a completely credit driven environment, and have the situation where you have to pay up front for management and transaction costs. You get the collateral back if you miss a management repayment and it's up to you.

OK. I put my gold into a bank. Now I want to use that gold to buy a hamburger. The
trouble is that the guy with the hamburger does not want 0.005 bricks of gold. He wants
US Federal Reserve Notes. What happens?

OK. I find a hamburger person that is willing to take ownership of 0.005 bricks of gold. If I go back to the bank and ask for my gold back, and they give it to me, then that hamburger sales person is going to be rather annoyed.

Also, I don't see the point of this. I have put a reasonable chunk of my wealth into gold. I have put my gold in a secure location, so that if all hell breaks loose, I have access to that gold. Either things don't blow up or they do. If they don't blow up then going through all of this trouble is sort of pointless. If things do blow up, then I'm not going to trust *ANYONE*. If things get really bad, then I want my gold in my hands, because if things get that bad, then there is a reasonable chance that the stuff that got put into the "bank" is gone because someone would have taken it. Maybe the person I left the gold with has taken it and run away. Maybe some people have pointed guns at him taken everything.

The nice thing about gold is that it's very compact, so if things to to hell, I can carry it with me.

So this is a lot simpler without any real restructuring of what already exists.

It's not "a lot simpler". If you look at the agreement that you would be willing to sign, it's likely to be three pages of fine legalese.

Also if you really want to do this sort of stuff, there are things like digital currencies and e-gold. These haven't been popular because they force you to transact in an alternative currency that isn't backed by a government with nuclear weapons.

 

[chiro]

At which point you have a secured loan or mortgage. You give the bank collateral. The bank deposits cash into your account, you can then exchange that cash with anything you want. You pay the bank a fee (lets call it "interest") and the bank makes money from that.

It's not interest though in the traditional sense: it's more like the monthly fee the bank charges you to have account and manage it.

Again it has nothing to do with credit whatsoever: this is the key thing.

And they do. You can go to a bank with a house, the bank will give you cash. The fact that it was ridiculously easy to convert houses into cash was what caused this problem in the first place.

Having real collateral vs a credit instrument is a completely different scenario: they are not the same and they don't have the same effect.

It's not like the house purchases or the situation involved pure collateral.

Now you could argue that that cash step is unnecessary. The bank should be able to take your house and then sell a fraction of it. The trouble is that if you buy burgers from me, I don't want 0.0005% ownership of your house. I want cash.

I did mention there was a premium for this and the transaction premium was to take into account this very scenario: I did not say it would be free or easy (especially to start up).

It's the same kind of thing when you purchase an international bank cheque when you want to do international transactions: you pay a premium for the transaction to take place on top of the actual value of the transaction itself.

I understood this problem which is why I mentioned the premium and the choice for this to be available in the public domain. It's not going to be free by any means.

The burger joint will get their money when your manager deals with the transaction.

Also be aware you don't have to "move collateral" or settle things for every transaction. You can do a batch setup for example.

OK. I put my gold into a bank. Now I want to use that gold to buy a hamburger. The trouble is that the guy with the hamburger does not want 0.005 bricks of gold. He wants US Federal Reserve Notes. What happens?

What happens is that you make a transaction agreement and a management agreement (it is not interest based and it is not a loan in the tradition sense: if you don't pay upfront you get your collateral back and it becomes your problem to manage it).

The bank sets up for you a way to be able to do transactions with external parties for some pre-defined value. When you get close to reaching the limit, you get a new batch.

The batch transaction allows you to make so many transactions with a third party for whatever their medium of exchange is.

The transactions are of course made between the entity managing your collateral and the merchants bank who is offering the transaction capability.

This kind of thing happens now and a real example is when you have to get an international bank cheque. I've done this kind of thing when purchasing stuff from overseas (particularly the UK).

The cost of doing this is reflected in the transaction and management costs.

Again it is not a loan: everything is up-front and you will always get the remaining collateral back that hasn't been used up, even if you miss a payment for new management in which you get it all back and then it becomes your problem.

OK. I find a hamburger person that is willing to take ownership of 0.005 bricks of gold. If I go back to the bank and ask for my gold back, and they give it to me, then that hamburger sales person is going to be rather annoyed.

As I said before, it's an agreement that have to be made between the non-credit entity and the credit entity and this is what happens anyway when you deal with multiple currencies and other non-paper exchange.

The link to a credit-based institution to convert non-credit into some form of credit will come at some expense of course.

Also, I don't see the point of this. I have put a reasonable chunk of my wealth into gold. I have put my gold in a secure location, so that if all hell breaks loose, I have access to that gold. Either things don't blow up or they do. If they don't blow up then going through all of this trouble is sort of pointless. If things do blow up, then I'm not going to trust *ANYONE*. If things get really bad, then I want my gold in my hands, because if things get that bad, then there is a reasonable chance that the stuff that got put into the "bank" is gone because someone would have taken it. Maybe the person I left the gold with has taken it and run away. Maybe some people have pointed guns at him taken everything.

I understand, but the point is not to pledge the collateral for a loan. You have to pay everything up front in terms of fees and as a result (at least legally), you always have the ability to take your collateral out and if you miss a new payment, they are forced to give it back to you.

The real issue is that in a loan, the bank can always confiscate your money or your collateral but in this situation you are the one that is paying for the collateral to be managed and used in a transactional capacity.

The nice thing about gold is that it's very compact, so if things to to hell, I can carry it with me.

I guess in a nutshell, what this would do is provide a link to take that and link it up with the existing credit system.

Basically people have a choice of taking the metals and having a regulated entity deal with taking the collateral and using it with the existing infrastructure.

If things go to hell then that's another issue, but the point of the suggestion was to facilitate management of transactions using collateral that was non-interest and non-credit related.

It's not "a lot simpler". If you look at the agreement that you would be willing to sign, it's likely to be three pages of fine legalese.

Also if you really want to do this sort of stuff, there are things like digital currencies and e-gold. These haven't been popular because they force you to transact in an alternative currency that isn't backed by a government with nuclear weapons.

I see what you mean, but I am seeing the move towards gold and silver becoming pretty prominent.

When things get really bad (if they get really bad) then people will want to eventually (when the time is right), return to some kind of standard whereby you can guarantee some kind of stability and trust and when this happens, the idea of using precious metals will be taken more seriously.

There are countries that are moving to some form of precious metal trades in things like oil right now and the CME is even accepting gold as collateral.

Once you have this happen a lot significantly in an environment where people finally are able to trust each other, then the idea of having the above is not really a far fetched one even amid all the political and military BS (it's not that you are wrong, but it's just really stupid BS that's going on) that's happening right now.

China is (or has) opened what is called the PANAM which is a gold exchange that stores the physical and isn't just a "paper promise" that is done in the ETF's.

If gold and silver catches on like it would in a collapse and environment of dis-trust, then the suggestion is going to be a lot more favorable as opposed to going back to a system that created the distrust.

Again I'll summarize that the basic idea is that it is not a loan: you do not pledge collateral to obtain a loan of any kind where you have the promise to pay it back and where the bank can legally hold it: instead you pay the entity fee in some way to manage/hold your collateral and to do the business of transacting with 3rd parties.

This happens to a large extent when you have to trade with people in different currencies or under different situations, so the mechanisms for 3rd party transactions like the example of internal bank cheques are well understood.

 

[chiro]

The idea is going to be foreign to pretty much everyone because everyone is used to this idea that if you put money in the bank that you give the bank money that will give you interest. Most people can't comprehend the point of paying someone to look after your money/collateral/whatever in a non-credit context and I can understand why on many levels.

Originally this is what the real merchants did anyway and you could always get your gold back at any time.

I'm not saying we have to do it like they did back then: there are better ways of doing the same kind of function that occurred when the desk jockeys (i.e. the merchant bankers) were moving gold everywhere.

We can achieve the same sort of thing and integrate it into the existing system by looking at how all of the 3rd party transaction systems have been setup and the context behind those setups.

It's always good to have competition as well: the competition allows choice and with real choice (not some BS version of it), people can make a real choice and live with the consequences of doing so and I'm all for that.

Also as you said, the great thing about gold is that its divisible which means you can put in 20 coins and use one at a time.

 

[twofish-quant]

It's not interest though in the traditional sense: it's more like the monthly fee the bank charges you to have account and manage it.

One thing about financial instruments is that they are convertible. Even if the
bank calls it "fees" you can calculate an equivalent interest rate. If it's different
from the prevailing interest rate, then there is financial incentive to change the
fees to match the prevailing interest rate.

Again it has nothing to do with credit whatsoever: this is the key thing.

If it doesn't have anything to do with credit then I don't see what the point of
this exercise is. Presumably you have an asset (like a house), you want to convert
it to something else (like a hamburger). This involves converting it into an intermediate
instrument (like Federal Reserve Notes). In the process of doing this, someone is
going to keep records about what is owed. The language of those records are going
to involve accounting, and that involves credit, debit, assets, and liabilities.

Having real collateral vs a credit instrument is a completely different scenario: they are not the same and they don't have the same effect.

Mathematically they are the same. One thing that is important is that in most financial situations, you don't actually physically move the collateral. What you are moving are
pieces of paper that confer ownership and borrowing rights.

The burger joint will get their money when your manager deals with the transaction.

The burger joint wants payment *now*, and in *money*. When I go to McDonalds,
they demand payment in Federal Reserve Notes or credit cards that transfer cash. If I
go to McDonalds and I show up with gold, bank IOU's, US treasury notes or anything other
than cash, I'm not going to get my burger.

There are lots of people that will take green slips of paper with pictures of dead presidents
on them. If you have a bank try to convert your assets into anything other than colored
paper, you will have problems with people accepting that to resolve a debt.

If this thing is going to be useful, then you have to be able to convert assets into cash,
once you do that, you've just gotten a secured loan.

What happens is that you make a transaction agreement and a management agreement (it is not interest based and it is not a loan in the tradition sense: if you don't pay upfront you get your collateral back and it becomes your problem to manage it).

Even if the payment isn't specified in terms of interest, it can be mathematically converted into an equivalent interest rate. This happens all of the time with bonds.

If you want to convert this into cash, then it's a loan. If you talk about "collateral" then it's a loan, because without a loan somewhere, there is no point in talking about collateral. Now you can have a situation in which you pay a bank to safeguard valuables (i.e. coins in a safety deposit box), but that has nothing to do with collateral.

If it's not a loan, then this doesn't make any sense. I give the bank the deed to my house. The bank gives me someone that I use to buy a hamburger. If I try to get my deed bank without repaying the assets that the bank used to by the hamburger, then the bank is going to be annoyed.

The bank sets up for you a way to be able to do transactions with external parties for some pre-defined value. When you get close to reaching the limit, you get a new batch.

This is either a secured loan or a secured line of credit. The bank takes your thing of value, gives you cash which you can use to buy stuff. If you replace the cash that the bank has, you get your stuff back. If not, then not.

The transactions are of course made between the entity managing your collateral and the merchants bank who is offering the transaction capability.

This is still a secured loan. The bank has to keep track of how much stuff you spent.

This kind of thing happens now and a real example is when you have to get an international bank cheque. I've done this kind of thing when purchasing stuff from overseas (particularly the UK).

Right, and what you've just bought is a transferable letter of credit. You've just loaned money to the bank, the bank has given you a transferable IOU, you give the transferable IOU to someone else, and the bank pays back your loan to the person holding the IOU.

In the US, people will prefer payment in US dollars versus bank letters of credit. For international transactions people will often prefer payment with bank letters of credit. So banks move things between the two depending on what you want and take a charge for it.

That's fine. But you seem to be under the mis-impression that this has nothing to do with credit when it fact it has *everything* to do with credit. The bank cheque is an IOU from the bank to you (or the holder of the check).

Again it is not a loan: everything is up-front and you will always get the remaining collateral back that hasn't been used up, even if you miss a payment for new management in which you get it all back and then it becomes your problem.

If you give security to the bank, and you get cash upfront, then it's a secured loan. If you pledge security to the bank and you get cash as needed then it's a secured line of credit. I have one of those using the value of my house as security.

I understand, but the point is not to pledge the collateral for a loan. You have to pay everything up front in terms of fees and as a result (at least legally), you always have the ability to take your collateral out and if you miss a new payment, they are forced to give it back to you.

If it's not a loan, then I don't understand what you mean by collateral. In standard banking language, if you don't have a loan, then there is no collateral anywhere. If you can't seize the asset in case of default, than it's not collateral. It's something else.

Also this makes no sense from the banks point of view. You've given the bank a thing of value. If you miss a payment, then the bank is likely to *insist* that they can seize the asset. Why should the bank take the risk that you are going to be a dead beat?

The real issue is that in a loan, the bank can always confiscate your money or your collateral but in this situation you are the one that is paying for the collateral to be managed and used in a transactional capacity.

I'm getting very confused because you are inventing your own financial terms. By *definition* collateral is an asset that is security for a loan.

http://en.wikipedia.org/wiki/Collateral_(finance)

Inventing your own financial and accounting language makes no sense, because
when people get stuff from you, they are going to insist that you use the standard
terminology, which involves credit, debit, asset, liability. If the bank takes assets from
you then something is going to be entered on the books as a credit.

When things get really bad (if they get really bad) then people will want to eventually (when the time is right), return to some kind of standard whereby you can guarantee some kind of stability and trust and when this happens, the idea of using precious metals will be taken more seriously.

If things get that bad (and my parents have seen things get that bad), then none of this
matters. If you are at the point were you want precious metals, then there is no point
in talking about brokers, banks, collateral, assets, or transactions. At that point we are
talking about the law of the jungle. If things really get bad enough so that I need gold,
then I want the gold in hand. One family story involves my mother going to Taiwan as a
12 year old, and in order to keep some stuff away from the communists, my grandmother sewed pieces of gold into her overcoat. I think I may still have a piece, even though it
was illegal to own it in the US until 1975.

But if you are at that level, then this discussion is pointless, because if we are at that
level, then things have broken down that I'm just not going to trust putting my wealth
in *any* institution. The good thing about it, is that if things have broken down that
much, then tiny pieces of gold are going to be insanely valuable, and one nice thing about
gold is that you can have large amounts of wealth on your person.

China is (or has) opened what is called the PANAM which is a gold exchange that stores the physical and isn't just a "paper promise" that is done in the ETF's.

If I am not physically holding the gold (i.e. it's not in my hands), then it's a "paper promise." I'm trusting that the person that is storing the gold will hand it to me. There are historical situations where this hasn't happened (i.e. Roosevelt in 1933).

Again I'll summarize that the basic idea is that it is not a loan: you do not pledge collateral to obtain a loan of any kind where you have the promise to pay it back and where the bank can legally hold it: instead you pay the entity fee in some way to manage/hold your collateral and to do the business of transacting with 3rd parties.

1) This is not collateral.
2) It might be a secured line of credit which banks do all the time.
3) A lot depends on the nature of the asset. If you have gold coins, then you just pay the bank to hold it in the safety deposit box, and sell the coins to a coin dealer when you need cash. If you want to convert a house to cash, there are a lot of other issues.

This happens to a large extent when you have to trade with people in different currencies or under different situations, so the mechanisms for 3rd party transactions like the example of internal bank cheques are well understood.

And those involve loans and "letters of credit". When you pay money to a bank in exchange for a bank cheque, you are providing the bank with a loan, and the bank is giving you a letter of credit. When you deposit cash and get a bank cheque, the bank does not hold the money that you deposit and put it into a shoebox. It marks the cheque as a liability, and the money as an asset, and it can (and does) use that money to loan out.

 

[twofish-quant]

The idea is going to be foreign to pretty much everyone because everyone is used to this idea that if you put money in the bank that you give the bank money that will give you interest.

This isn't true for small checking accounts. Banks usually lose money on those, because the cost of maintain a checking account with say $500.00 in it is a lot more than the interest. The reason that banks offer free checking is that it's a "loss leader". Whenever you go into the bank to do something with your checking account, there will be a nice loan officer asking if you are interested in a credit card. Also if they can get you to refinancing your home, then they've hit the jackpot.

The big thing that you get putting your money in a bank is FDIC insurance.

When you go to a US bank and get a car loan, the money does *not* come from the bank's depositors. What happens is that the bank repackages the loan and ultimately the money comes from China, Russia, or the Middle East.

Most people can't comprehend the point of paying someone to look after your money/collateral/whatever in a non-credit context and I can understand why on many levels.

1) You are paying a bank to look after you money. The interest rate on a mortgage right now is about 3%. You are lucky if you get 1% in a savings account, and you get slapped with a ton of fees on checking.

2) If you are a major Fortune 500 company, then you aren't going to be putting most of your money into bank accounts. If you have several billion dollars to manage, then you will hire a portfolio manager that will invest your money directly into commercial paper, repurchase agreements, government treasuries, etc. etc., and it turns out that the returns on those are much higher than putting your money in a bank.

The name for this is the "shadow banking system."

We can achieve the same sort of thing and integrate it into the existing system by looking at how all of the 3rd party transaction systems have been setup and the context behind those setups.

It's called the "shadow banking system." It broke down and blew up in 2008. The nice thing about banks is that when you have a ton of people trying to withdraw their money at the same time, there is a mechanism for dealing with that. What was really scary about 2008, is that you had something like that happen, and there wasn't an obvious way of dealing with it.

It's always good to have competition as well: the competition allows choice and with real choice (not some BS version of it), people can make a real choice and live with the consequences of doing so and I'm all for that.

It's not always good to have competition. The thing is that wholesale interest rates are pretty standard. If wholesale rates are standard then how do some banks offer better interest rates? Well, one way is by cutting reserves and doing risky stuff. This creates a "reverse Darwin" in which less money went to banks with decent risk management, and more banks went into banks that did stupid stuff, because banks that did stupid stuff were able to offer better rates.

Because of competition, if you were a deadbeat and couldn't get a loan from "smart bank" you went to "bank of idiots" and got your money. The other problem is that people's choice can affect other people. When "bank of idiots" exploded it, people that worked at "smart bank" got fired too.

Competition can be good, but it's not *always* good.

 

[chiro]

One thing about financial instruments is that they are convertible. Even if the bank calls it "fees" you can calculate an equivalent interest rate. If it's different from the prevailing interest rate, then there is financial incentive to change the fees to match the prevailing interest rate.

I understand why this is hard because I am not talking about any interest bearing instrument: I'm talking about the exact opposite. It's a concept that is completely foreign in many banking systems, particularly western ones.

The point of this is to put something in a bank that is a form of collateral that bears no interest and legally does not have any of the obligations that a credit agreement has.

Credit agreements work on the principle that there is a dependency between the creditor and debtor and there is some kind of shared "ownership" whereby the different terms dictate how the final ownership is transferred in terms of the underlying asset and the mechanism of credit.

I am not referring to anything based on this: the agreement is such that you pay up-front someone to manage your collateral and perform the function of doing exchange with other parties in same kind of way 3rd party exchange works.

The institution itself will have to figure out how it can take a portion of that collateral (for example if you have lots of silver or gold coins) and then come to an agreement with 3rd party institutions on how exchange will be done so that you can integrate into the existing system, but from the point of the person who owns the collateral not already tied up in an existing transaction (including a batch one), they legally own the rights to all other collateral that is being managed and that has not been transacted by the management for use of exchange between the management and a 3rd party (like the rest of financial system that uses the EFTPOS machines, ATM's and so on).

The key difference is that again, you pay the management up-front for management and you also pay up-front for transactions (you would do this in batch) where you surrender part of your collateral to be converted by the management for use in external transactions.

You pay for a premium for this privilege since you can always take out the remaining collateral at any time and if you don't pay an upfront fee to keep it managed, they must return the collateral back to you and it becomes your problem.

If it doesn't have anything to do with credit then I don't see what the point of
this exercise is. Presumably you have an asset (like a house), you want to convert
it to something else (like a hamburger). This involves converting it into an intermediate
instrument (like Federal Reserve Notes). In the process of doing this, someone is
going to keep records about what is owed. The language of those records are going
to involve accounting, and that involves credit, debit, assets, and liabilities.

There is a point to this.

Think about firstly a bank run. These institutions require a premium that protects against such an occurence.

In fact the whole point of the exercise is to protect people from the horrors that occur when dealing with credit. If credit works then fine, you will not "gain" what you could have and you will be stuck with dealing in costly transactions with 3rd parties which will be expensive.

But when the credit system goes belly up, you will have the advantage.

This is the point.

Mathematically they are the same. One thing that is important is that in most financial situations, you don't actually physically move the collateral. What you are moving are pieces of paper that confer ownership and borrowing rights.

This is not even close to being the same: this is not the same as a standard credit arrangement.

Also I'm not advocated moving collateral every time a transaction is made: one would look at the many 3rd party agreements between institutions involving exchange and do a form of a batch exchange where portions are converted to credit with the authority of the owner if they were to deal with credit-based institutions for doing financial transactions.

The person could do this themselves by simply buying gold and silver and cashing out when they want to, but the point of this is the same point that people put cash in the bank and not under their mattress.

The burger joint wants payment *now*, and in *money*. When I go to McDonalds, they demand payment in Federal Reserve Notes or credit cards that transfer cash. If I go to McDonalds and I show up with gold, bank IOU's, US treasury notes or anything other than cash, I'm not going to get my burger.

I've covered this above and I was aware of this.

There are lots of people that will take green slips of paper with pictures of dead presidents
on them. If you have a bank try to convert your assets into anything other than colored
paper, you will have problems with people accepting that to resolve a debt.

This is just plain wrong: the CME has announced it will take gold as collateral.

You have overseas trade outside the US that deals in gold and you have the PANAM in Asia.

You also have central banks buying up tonnes of gold themselves.

Some people are getting rather sick of the dead presidents don't you think?

Also people can liquidate gold and silver now very easily, especially when people want to buy it up. There is absolutely no problem with this now by a long shot.

If this thing is going to be useful, then you have to be able to convert assets into cash, once you do that, you've just gotten a secured loan.

The way things are structured now then yes, for transactions the transacted part of collateral that has been agreed to be transacted would be turned into some form of currency.

The point though is to have a firewall.

Even if the payment isn't specified in terms of interest, it can be mathematically converted into an equivalent interest rate. This happens all of the time with bonds.

This is not a mathematical thing: this is about having an entity that does controlled liquidity in a very specific way with collateral where you pay a premium to hold all the collateral and do liquidation again in a very controlled, specific manner.

If the market decided that this was popular then I'd imagine that people might transact in some other currency or other form, but that is not the issue here: the issue here is that you ask some entity to manage your collateral and pay them a management fee and then ask them to administrate the transactions where asking you up-front on how you would like to liquidate portions of such collateral so that exchange can be done with 3rd parties.

The way we do it know is through certain markets where gold and silver (and other forms of collateral) can be exchanged for whatever else, but the medium of exchange is not the issue here: the issue is the nature of the liquidation process and the nature of the management and transaction which is not what happens now.

If you want to convert this into cash, then it's a loan. If you talk about "collateral" then it's a loan, because without a loan somewhere, there is no point in talking about collateral. Now you can have a situation in which you pay a bank to safeguard valuables (i.e. coins in a safety deposit box), but that has nothing to do with collateral.

I think I have misused the word collateral and I apologize. Again I think I've explained the basic idea above.

If it's not a loan, then this doesn't make any sense. I give the bank the deed to my house. The bank gives me someone that I use to buy a hamburger. If I try to get my deed bank without repaying the assets that the bank used to by the hamburger, then the bank is going to be annoyed.

I understand that it's hard to grasp because people are so used to thinking about only credit which has the implication of a loan instead of a non-credit form of simple exchange.

All credit agreements have termination criteria so if you want to compare it to that, then the termination criteria is essentially instantaneous since the full scope of the exchange takes place immediately.

This is either a secured loan or a secured line of credit. The bank takes your thing of value, gives you cash which you can use to buy stuff. If you replace the cash that the bank has, you get your stuff back. If not, then not.

This is still a secured loan. The bank has to keep track of how much stuff you spent.

This is not a conventional loan: see the above comment. I do empathize that most people are not familiar with such a situation.

Right, and what you've just bought is a transferable letter of credit. You've just loaned money to the bank, the bank has given you a transferable IOU, you give the transferable IOU to someone else, and the bank pays back your loan to the person holding the IOU.

The point of the system is to settle the "loan" immediately if you want to call it a "loan". I'd equate it to the state of when a person pays their final house payment and the termination clause is met except that in this instance, all of this happens rather quickly.

In the US, people will prefer payment in US dollars versus bank letters of credit. For international transactions people will often prefer payment with bank letters of credit. So banks move things between the two depending on what you want and take a charge for it.

Yes that is the nature of 3rd party exchange: the medium is not important since any new medium can be invented depending on what happens.

That's fine. But you seem to be under the mis-impression that this has nothing to do with credit when it fact it has *everything* to do with credit. The bank cheque is an IOU from the bank to you (or the holder of the check).

When transacting, there will definitely be a credit arrangement of sorts for each transaction and I concede that.

The point though is that you have an entity that does controlled liquidity and management of your assets.

Here's the brief outline: in an uncontrolled credit environment you have the possibility of bank runs, huge defaults, and lots of crisis which can wipe out value that people may never ever get back in the case of a crisis or collapse.

In the situation I'm proposing, people will still have to do exchange and some form of credit will eventually come in but the point is to have someone who manages your stuff of value and tightly controls the liquidity of said stuff where they do not legally own your value of stuff (you don't pledge it in the normal sense) since you have to pay a premium for them to store it, secure it, and manage it and you also have to authorize them to do new batch transactions to convert said stuff to things that they can use to exchange with the outside world.

The entity has the responsibility of doing both the 3rd party exchange in whatever way it can (and hopefully the best way) and to administrate your valuable "stuff" in a controlled way.

The thing about pledging collateral for loans is that there are ownership issues and termination/default clauses for who gets assets (and in bankruptcy there are a whole lot of different issues regarding how such a situation is handled depending on who goes bankrupt and what they do for a living).

This issue doesn't exist in my situation: it's not the same thing. It's a completely different contract, and not the same kind of contract that someone signs in a normal situation that they do with a regular bank.

This may be minor, but it's really important.

It has its advantages and its disadvantages.

The disadvantage is that you have to pay to have your stuff administered and for the entity to set you up with a way to transact with other parties (like the burger joint with an ATM) and in a situation where the credit systems are sound and in good shape, you will lose a lot of potential advantages that you would other-wise have in the kind of institutions we have now.

The advantage is when things go belly up. You're stuff is still there and it will probably rise in value, but the exchange mechanisms are in place where you don't have to worry about what to do in the said situation. The security and management already exists as well so you won't have to worry about getting robbed when you are hiding your stuff under your mattress.

The other point is that having this means that if you have enough of these in existence, then you prevent more social deterioration since an organized exchange medium already exists. This is ultimately the most compelling point about such an entity and it's a primary reason for why I am suggesting it.

When you already have an organized body that is part of the system itself, then as long as you have that strong element there you minimize the kinds of social chaos that would ensue if it were not there as an alternative for people to use.

It has its advantages and its disadvantages but the main advantage is to handle a hundred year flood that really screws things up.


If you give security to the bank, and you get cash upfront, then it's a secured loan. If you pledge security to the bank and you get cash as needed then it's a secured line of credit. I have one of those using the value of my house as security.



If it's not a loan, then I don't understand what you mean by collateral. In standard banking language, if you don't have a loan, then there is no collateral anywhere. If you can't seize the asset in case of default, than it's not collateral. It's something else.

Also this makes no sense from the banks point of view. You've given the bank a thing of value. If you miss a payment, then the bank is likely to *insist* that they can seize the asset. Why should the bank take the risk that you are going to be a dead beat?



I'm getting very confused because you are inventing your own financial terms. By *definition* collateral is an asset that is security for a loan.

http://en.wikipedia.org/wiki/Collateral_(finance)

Inventing your own financial and accounting language makes no sense, because
when people get stuff from you, they are going to insist that you use the standard
terminology, which involves credit, debit, asset, liability. If the bank takes assets from
you then something is going to be entered on the books as a credit.



If things get that bad (and my parents have seen things get that bad), then none of this
matters. If you are at the point were you want precious metals, then there is no point
in talking about brokers, banks, collateral, assets, or transactions. At that point we are
talking about the law of the jungle. If things really get bad enough so that I need gold,
then I want the gold in hand. One family story involves my mother going to Taiwan as a
12 year old, and in order to keep some stuff away from the communists, my grandmother sewed pieces of gold into her overcoat. I think I may still have a piece, even though it
was illegal to own it in the US until 1975.

But if you are at that level, then this discussion is pointless, because if we are at that
level, then things have broken down that I'm just not going to trust putting my wealth
in *any* institution. The good thing about it, is that if things have broken down that
much, then tiny pieces of gold are going to be insanely valuable, and one nice thing about
gold is that you can have large amounts of wealth on your person.



If I am not physically holding the gold (i.e. it's not in my hands), then it's a "paper promise." I'm trusting that the person that is storing the gold will hand it to me. There are historical situations where this hasn't happened (i.e. Roosevelt in 1933).



1) This is not collateral.
2) It might be a secured line of credit which banks do all the time.
3) A lot depends on the nature of the asset. If you have gold coins, then you just pay the bank to hold it in the safety deposit box, and sell the coins to a coin dealer when you need cash. If you want to convert a house to cash, there are a lot of other issues.



And those involve loans and "letters of credit". When you pay money to a bank in exchange for a bank cheque, you are providing the bank with a loan, and the bank is giving you a letter of credit. When you deposit cash and get a bank cheque, the bank does not hold the money that you deposit and put it into a shoebox. It marks the cheque as a liability, and the money as an asset, and it can (and does) use that money to loan out.[/QUOTE]

 

[chiro]

With regard to your last comment on competition:

Why wouldn't you just let the idiot banks fail like you would let a reckless business fail?

Also before you say because of "systemic risk" (i.e. due to things being sold and chopped up many many times), then the other thing is that if these banks with loans basically lied to the people they sold these things too, then this is just fraud.

But even then, the people that buy these things are either really brainwashed with $ signs or really stupid. If they want to make a decision like this and they know it's just "too good to be true", then why should they get bailed out?

So in the case of idiot bank you have at least two things: one is fraud and the second thing is that you have people that are meant to be competent investors, fund managers, or these so called investment banks that buy this stuff knowing that it's probably a "pipe dream" and then it goes down the line.

If I'm stupid enough to throw 20,000 on the craps table at vegas and lose it all then I deserve to lose it all. Why is it different for these people?

The other thing is that the leverage is so ridiculously high and the game is rigged: no ordinary citizen can do what these banks do. They operate on the "exception" to the rule rather than on the rule itself.

If they operated on the rules then a lot of them would be in jail.

 

[twofish-quant]

I understand why this is hard because I am not talking about any interest bearing instrument: I'm talking about the exact opposite. It's a concept that is completely foreign in many banking systems, particularly western ones.

Part of the problem that I'm having is that you are using very non-standard terminology,
and I'm having to spend a lot of effort trying to understand what you are trying to
propose.

What you are proposing is not "collateral." What you are talking about is a brokerage
account. When you open an account with a broker, and buy stock or bonds or gold,
the broker does not own any of that. They execute orders for you, and if the broker
goes bankrupt, that (theoretically) doesn't impact you because the broker doesn't
own anything in your account.

US commercial banks would *LOVE* to enter the retail brokerage business. However,
they can't because of some rather complicated laws that effectively banks from doing
brokerage operations to retail consumers.

I am not referring to anything based on this: the agreement is such that you pay up-front someone to manage your collateral and perform the function of doing exchange with other parties in same kind of way 3rd party exchange works.

It would help if you don't call it collateral. Brokerage accounts work exactly this way.
Also large corporations don't get loans from banks. Typically what happens is that a large
corporation hires a bank to provide advisory services and asset management. The bank
directly buys and sells from the securities markets. If a big company wants a loan, then
don't get it from the bank, they have the bank execute a repurchase agreement, issue
commercial paper, or issue bonds.

The thing about this system is that it has weak points that weren't totally obvious before
2008. Among other things if you can get money to finance mortgages directly from the
financial markets, that let's you bypass a lot of things like reserve requirements and consumer protection laws.

The key difference is that again, you pay the management up-front for management and you also pay up-front for transactions (you would do this in batch) where you surrender part of your collateral to be converted by the management for use in external transactions.

OK. I'm going to pretend that you aren't using the term collateral, and replace it with asset.

That's what investment banks do. For anyone that has more than say $1 million, it makes no sense to deposit that money in a bank. FDIC insurance covers you only up to $100,000, and the larger the amounts of money, the more sense it makes to pay a flat fee for treasury services and deal directly with the markets.

Also if you have that much money, then instead of getting "canned" products, you can have the bank design contracts and products that are specially tailored.

Think about firstly a bank run. These institutions require a premium that protects against such an occurence.

1) It doesn't. What happens is that you have lots of institutions that are competing for deposits. The lower your reserves are and the more stupid you are, the lower your fees are.

2) It doesn't prevent runs. What happened in 2008 is that people got really scared and at that point they called up their brokers and told them to sell everything that they had and buy US government bonds. Once everyone tries to sell everything at once the markets disintegrated.

In fact the whole point of the exercise is to protect people from the horrors that occur when dealing with credit.

Well it doesn't work then. OK suppose you are a smart guy that puts money into stock or bonds or anything else. Some idiot that is up to his neck in debt gets a call from his broker saying that he needs to pay up. What does the idiot do, he sells. What does that do to your wealth? It kills it. So you end up having to sell your stuff.

But when the credit system goes belly up, you will have the advantage.

No you won't. Because if the holder of your funds goes under then you are stuffed. You will have to wait in line in bankruptcy court with everyone else for months while people figure out who owns what. In the mean time, you have to eat.

Also if the financial system blows up, the assets you put into the system are likely to be worthless anyway. Even if you put gold into the system, the companies that store the gold may have gone belly up, so good like getting money out. Once you get the gold out, then what do you do with it?

The person could do this themselves by simply buying gold and silver and cashing out when they want to, but the point of this is the same point that people put cash in the bank and not under their mattress.

If you think the world is going to end, this makes no sense.

The issue here is that you ask some entity to manage your collateral and pay them a management fee and then ask them to administrate the transactions where asking you up-front on how you would like to liquidate portions of such collateral so that exchange can be done with 3rd parties.

Which is what investment banks and brokerage firms do. The trouble is that if the investment bank is undertaking stupid transactions that you are unaware of then you are stuffed in a crisis.

In the situation I'm proposing, people will still have to do exchange and some form of credit will eventually come in but the point is to have someone who manages your stuff of value and tightly controls the liquidity of said stuff where they do not legally own your value of stuff (you don't pledge it in the normal sense) since you have to pay a premium for them to store it, secure it, and manage it and you also have to authorize them to do new batch transactions to convert said stuff to things that they can use to exchange with the outside world.

You are describing the system that collapsed in 2008 (a.k.a the shadow banking system).

The trouble is that if that if the person who is managing your funds is doing something really stupid like buying tons of bad mortgages and they go out of business then you are stuffed. Even if the stuff they are holding is legally yours, you won't be able to get access to it, and once you do get access to it you won't be able to convert it into cash.

The bigger problem is that without tight government regulation, there are all sorts of stuff that encourage that entity to do stupid things.

The entity has the responsibility of doing both the 3rd party exchange in whatever way it can (and hopefully the best way) and to administrate your valuable "stuff" in a controlled way.

And if they make more money by being stupid... Why should the entity be "smart" if it can make more money being stupid and careless? What are you going to do? Go somewhere else? If you are in a situation where you make more money being stupid and careless, then the only thing that will help is altruism, and that's not a very good system to depend on that.

The advantage is when things go belly up. You're stuff is still there and it will probably rise in value, but the exchange mechanisms are in place where you don't have to worry about what to do in the said situation. The security and management already exists as well so you won't have to worry about getting robbed when you are hiding your stuff under your mattress.

No. That's not what happened in 2008.

Suppose you have gold coins that are held by a brokerage firm that goes belly up. Fine, I still have my gold coins. Not fine. Those coins are now useless, because there is no way to covert them to cash. All of the brokers that could have converted stuff to cash have now gone belly up. Once you realize that this is going to happen, you then logically will sell everything you have and convert to something liquid like US Treasuries, since to convert Treasuries to cash you can go to the Federal Reserve.

Once everyone converts stuff to US Treasuries, then the price of *everything* other than treasuries collapses. One interesting thing about the crisis in 2008 was how the price of gold didn't go up very much. The reason for this is that in 2008, people were worried about converting gold to cash.

What ended up happening was that the Federal Reserve essentially said "don't worry" *we* will convert your stuff to cash.

Also one of the scary things was that at least in March, the mechanisms for dealing with an investment bank default *weren't there*.

The other point is that having this means that if you have enough of these in existence, then you prevent more social deterioration since an organized exchange medium already exists. This is ultimately the most compelling point about such an entity and it's a primary reason for why I am suggesting it.

And that exchange came pretty close to falling apart in 2008.

It has its advantages and its disadvantages but the main advantage is to handle a hundred year flood that really screws things up.

No it won't, because the system that you described is pretty much the system that failed in 2008.

 

[twofish-quant]

One other problem. You put your assets in an investment bank. The investment bank goes under. Now the assets are there and *theoretically* yours, but in reality they are unavailable. OK, you go to investment bank with your receipts in hand and demand your money. Trouble is that everyone has left the building. There's no one there to maintain the web sites, there's no one that is manning customer phones, nothing... There's no one to talk to in order to get your stuff. Yes legally, it's yours, but it might as well be on the moon.

 

[chiro]

I appreciate your comments and the education you are giving me on such matters.

To clarify one thing though: the people holding your stuff are not allowed to manage or invest your "valuable stuff" (I won't use the term collateral in the wrong way): the only thing they are able to do is to convert it to a medium that is a liquid interest-free thing like cash.

They don't manage things purely for the sake of investment purposes to get a "return on investment": the function is only to preserve the existing stuff of value and to transact portions of such stuff upon authorization so that it can be used primarily for the most liquid kind of exchange (i.e. cash).

You don't give the entity any extra power to do any investing or to do any kind of management for the expectation of a gain of some sort like most investors would: again it's a little foreign to most people because most people want to grow the value of their investments as opposed to simply trying to retain whatever value they had without the intention of growing it (even if they risk it declining as it is a possibility).

The obvious suggestion for "stuff of value" would be gold and silver primarily because it can easily be divided and this is essential if you want to take say a bunch of this stuff and use a few units per "batch transaction".

The manager can not use the stuff in any way other than to keep it secure and when authorized by you, to transact part of it so that it can be liquidated (if it can be liquidated, this is another issue but for this I am going on the history that at least for gold and silver, people still use it). They do not have the powers that a normal fund manager or other financial professional has and the regulations that govern them should make this extremely explicit.

So with regard to comments about these entities doing stupid things, the solution to this problem was to have these entities specifically designed for a purpose that is highly restricted in what it can do legally (by regulation) but that offers the public a way of doing this kind of thing if they choose.

I do agree there is the case where you may have to worry about getting said collateral out of the storage houses or vaults, but this is not related to the function of the financial aspect of the entity.

You could structure the security complex in such a way that people with swipe cards, biometric readers, or something else get access to their "stuff of value" and the problem becomes one of making sure the place is powered so that all the equipment is functioning.

Getting the assets out with the current technology should not really be as much of a problem as it used to be (it's not saying it's completely solved, but we have a lot more solutions now that are feasible).

As for why the entity can't be careless? Because it's designed to be a lot more restricted in its nature than many of the institutions now are.

 

[twofish-quant]

To clarify one thing though: the people holding your stuff are not allowed to manage or invest your "valuable stuff" (I won't use the term collateral in the wrong way): the only thing they are able to do is to convert it to a medium that is a liquid interest-free thing like cash.

Allowed by whom?

In the United States and most Western countries, something is legal until someone passes a law to make it illegal. So if you *invent* a "cash management agency" they it will be able to do whatever it wants until someone passes a law banning it. China has an easier time regulating finance because in China everything financial is illegal until someone makes it legal.

If CMA's take off, then by the time some gets around to regulating them they'll have a ton of lobbyists telling them that regulation is unnecessary. And if it gets banned in the US, people will do it in England.

This is what happened to brokerage firms. One big change is that a lot of the stuff that was done by a commercial bank in the 1960's is now done by brokerage firms, which were not before the crisis subject to the same regulations as commercial banks. If you are a mid-sized company with more than $10 million in assets, you are not going to deposit any more than a trivial amount of money in a commercial bank. You are going to find a brokerage firm (a.k.a. an investment bank) to directly invest your funds into assets which you own. It's more faster and the fees are a lot less.

Before 2008, the thinking was that there was no need to put brokerage firms with the same type of regulation as commercial banks. Since brokers didn't actually own the assets and all of the assets were owned by clients, what could go wrong?

Well...

They don't manage things purely for the sake of investment purposes to get a "return on investment": the function is only to preserve the existing stuff of value and to transact portions of such stuff upon authorization so that it can be used primarily for the most liquid kind of exchange (i.e. cash).

Two problems...

1) What happens if the firm goes under? You might own the assets, but if you arrive at the firm and all the lights are off and the computers are down, and everyone has gone home because no one is paying their salaries, you are stuffed. At that point, you have to wait in bankruptcy court to get your money and that could take *months*. In the mean time, you have no cash.

Now in the case of US commercial banks, this doesn't happen. If the FDIC thinks that a bank is going to go under, what they will do is to march in (usually on Friday night), and seize the bank. They immediately fire the senior management and then hold a quick auction lasting no more than a day to find a buyer for the bank. The goal is so that on Monday morning, when people arrive to the bank *everything is exactly the same* except that there is a piece of paper on the door saying that the bank is now run by new owners.

The trouble is that FDIC can do this for commercial banks because of special laws involving banking. These laws didn't exist for other types of financial institutions in 2008. In the US, the government can't randomly seize your business. Even if you are being extremely stupid, the government has to have a law that allows it to seize your business (and even then you can challenge the seizure in Court). There are such laws in the US for commercial banks, and one condition of getting FDIC insurance and a federal bank charter is that you agree that the government can take over your bank. These laws have existed for decades, which also means that they've been legally tested, and you won't be able to stop the process in court.

Now because I know that if an FDIC-insured bank is going to keep running whatever happens, then if I think my bank is going to fail, then I do... nothing... Now if I realize that I have my money in a financial institution, and when I ask what happens if when it goes under, the answer is "wait in line in bankruptcy court" the logical thing for me to do is to go down and demand my money NOW! Which is what started to happen right after Lehman collapsed.

Which gets you to the second problem...

2) What cash?

If you have a cash management agency, then the contract with them probably states not only that they can only convert your assets to cash, but that they *must* do so if you demand it. When you put your money into a major brokerage firm, there is usually a requirement that they liquidate your assets at a market price in a moment's notice if you demand it and hand you your money. If the broker cannot find an immediate buyer for those assets, the broker is often required to buy those assets themselves.

Now in a crisis situation, when everyone is running for the exits, you can run out of cash very quickly. If you were a commercial bank, this would not be a problem. If you start running out of cash, but you have assets then you go to the Federal Reserve who gives you a cash loan secured by your assets. But... You aren't a commercial bank. And when people see that you are running out of cash, the number of people demanding cash just increases.

There are two ways of dealing with this. One is to write into the contract that the broker can refuse to liquidate in a crisis and you be assured of getting your money immediately. This is standard for hedge funds. The trouble with this is that if you can't liquidate in a crisis then what's the point? The point of having a checking account is so that you can pull your money out in an emergency. In any case once you are in the crisis, the contracts have already been written.

The second way, is to tell the firm, you are really a bank and therefore are subject to the same benefits and regulation as commercial banks. This is what happened a few days into the crisis. The major independent investment banks rewrote their charters so that they were now commercial banks. The Fed then stepped in with emergency loans, so the brokers now had enough cash to liquidate things for their clients. Ironically, once people knew that there was enough cash to liquidate their holdings, people stopped wanting their money, so the run stopped.

All this happened one week into the crisis, and it was over in hours. I hate financial analogies, but in this situation it was a like an auto accident patient heading into an emergency room. There are usually a dozen things wrong anyone of which could kill the patient, and this was one of the five or six things that almost destroyed the financial system.

What happened afterwards was that Fed said to everyone "now that I've saved your rear ends, you are going to have to listen to my rules."

You don't give the entity any extra power to do any investing or to do any kind of management for the expectation of a gain of some sort like most investors would: again it's a little foreign to most people because most people want to grow the value of their investments as opposed to simply trying to retain whatever value they had without the intention of growing it (even if they risk it declining as it is a possibility).

Doesn't matter. If you the point of the account is to make cash available at a moments notice, then it's dangerous.

The other thing is that this is pretty common for large companies. If you are say an airline, you aren't holding financial assets for the purpose of investment. You are an airline, you make money by flying planes. Your financial assets are there so that you can do things like pay people's salaries or buy airplanes. So you aren't looking to maximize returns. So you have $50 million that is set aside for this weeks payroll or to pay for aviation fuel. What do you do with it? (You call your broker to enter into a repurchase agreement.)

The reason that the world almost blew up has to do with these sorts of transactions. If are an investment fund and you put $50 million into stocks, and it goes down by $2 million, big deal... That's happens every day.

If you are an airline, and you enter into a $50 million repurchase agreement to park your payroll funds until Friday, if it goes down by $1 million or if you get the money a day late, you are screwed.

The reason that the financial crisis was so severe is that it put those "bread and butter" daily business transactions at risk.

The obvious suggestion for "stuff of value" would be gold and silver primarily because it can easily be divided and this is essential if you want to take say a bunch of this stuff and use a few units per "batch transaction".

In practice what people use to store value for day to day transactions is US treasuries. There's also short dated commercial paper.

So with regard to comments about these entities doing stupid things, the solution to this problem was to have these entities specifically designed for a purpose that is highly restricted in what it can do legally (by regulation) but that offers the public a way of doing this kind of thing if they choose.

If you allow any choice then what will happen is that the money will move from the regulated entities to the unregulated ones because they will offer the same services at lower cost. That's exactly what happened with commercial banks and brokerage firms.

Very soon you will have the regulated institutions screaming for looser regulation on the (correct) argument that they won't be able to compete with the unregulated institutions otherwise. Ironically, you may end up with situation in which the unregulated firms are the heaviest supporters of regulation (as long as they don't get regulated) since it means less competition. US commercial banks really, really, really wanted (and still want) to do brokerage services, but it was the brokers that were against that.

It happens so often that there is a name for it "regulatory arbitrage."

Also, the system is so interconnected, that I do not think that it's possible to have a parallel safe system and an unsafe system. If something happens with the unsafe system it will destroy the safe system. You have to regulate systematically and globally.

I do agree there is the case where you may have to worry about getting said collateral out of the storage houses or vaults, but this is not related to the function of the financial aspect of the entity.

It actually is. Most financial assets are not physical. For example, a US Treasury bond is a computer entry and not a physical entity. For that matter even gold as a financial asset isn't a physical entity. The important thing is not the gold itself, but ownership of the gold. Physical possession means very little. What matters is not the gold but the record giving me possession of the gold.

As for why the entity can't be careless? Because it's designed to be a lot more restricted in its nature than many of the institutions now are.

But if it has to interact and compete with the current institutions, it's going to get crushed, and in a systemic crisis it's not going to help anyway. In Wall Street, there were smarter banks and dumber banks. If you have a situation in which dumb banks can blow up smart banks, then it's not going to help the overall situation.

 

[chiro]

Thank you for the detailed replies.

I only have one question and it's basically to ask for your opinion still going on with the main theme and it's this:

What is the closest thing that exists to the kind of suggestion I am making? If you could give examples for different kinds of clients ranging from governments and oil companies to the normal working person I would really appreciate that.

Also you mention regulatory arbitrage: are you aware of any papers, books, etc that deal with this concept in any detail at all?

The idea of analyzing regulatory arbitrage sounds like a good way to structure regulatory policies and even to structure administrative functions.

I do realize the "human element" in all this in which you get all the things you have mentioned above, but the idea of a regulatory arbitrage applied to many contexts (i.e. as a guiding template for regulation and construction of authority-granting institutions in general) seems like a good place to investigate.

To me, it seems that the theoretical ideal situation is to create a paradigm whereby everyone has the same arbitrage advantage and that the key then for the quants, scientists, mathematicians and policy makers is to find out what the constraints are for each entity in order to satisfy the system-wide arbitrage properties for each individual entity.

I remember in my financial calculus course how it was described that when the BS equation came, it was something both sides could agree upon.

I imagine that this discussion with regard to regulatory arbitrage might generate the same kinds of discussions that were happening before the Black-Scholes model.

Solving a system-wide arbitrage problem or realistically, moving towards a solution would probably help solve a lot of system wide problems in general indirectly.

What are your thoughts?

 

[twofish-quant]

What is the closest thing that exists to the kind of suggestion I am making? If you could give examples for different kinds of clients ranging from governments and oil companies to the normal working person I would really appreciate that.

It's pretty standard for large companies and governments to work with investment banks in a capacity in which the bank manages but does not own the assets. The closest thing that "ordinary people in the United States" can get is probably opening an account with a discount brokerage and then using it to buy assets.

One thing that's different between large institutions and individuals is that if you go to a brokerage, you will get only "standard products.' For large institutions, the investment bank will have a team of people figure out what you want and then custom design whatever it is that you want done.

If you go to a bank with $10K and tell them that you want X, Y, and Z done with your money, you'll get ignored. If you go to a bank with $100M and tell them that you want X, Y, and Z, then you'll be swarmed by teams of people ready and able to do X, Y, and Z. The reason for this is that if it costs $1M/year for the bank to put together a team, then for $10K, it's not worth it, but for $100M, it's cheap. If you have $10K, then you have to buy a mutual fund. If you have $100M, then you can start your own custom mutual fund, and it's probably cheaper for you if you do that.

Also you mention regulatory arbitrage: are you aware of any papers, books, etc that deal with this concept in any detail at all?

Not really. Finance is one of the fields in which a lot of stuff you learn by just watching people, and listening to office conversations. There's very little incentive to write any of this down in a textbook, and plenty of disincentives. For example, suppose you are a trader that understands how stock markets *really* work. Why would you write any of this down? Fame? In most of these fields, it's a *seriously bad* thing to be famous.

The idea of analyzing regulatory arbitrage sounds like a good way to structure regulatory policies and even to structure administrative functions.

Yup, which is why people were thinking a lot about it when the rules were getting rewritten around 2009 when Dodd-Frank was getting drafted. If you want to make any big changes
now, it's too late.

I do realize the "human element" in all this in which you get all the things you have mentioned above, but the idea of a regulatory arbitrage applied to many contexts (i.e. as a guiding template for regulation and construction of authority-granting institutions in general) seems like a good place to investigate.

One issue here is that (barring some sort of massive revolution) you *never* have a blank slate in which to create things from scratch. You have to at least start with the institutions that exist, and those institutions have interests.

The big thing that people were thinking about with Dodd-Frank, was the fact that regulatory arbitrage allowed some institutions to end up completely unregulated, and much of Dodd-Frank was to set things up so that everyone would have some degree of monitoring.

Much of this was intentional. There is a school of thought that was extremely popular before 2008 that was that governments are fundamentally incompetent and that unregulated markets are the best for the economy. If you really believe this and you figure out a way of making government regulation impossible through regulatory arbitrage, you are going to try to keep that loophole open. After 2008, there was a window in which you could make basic changes to the financial system, but that lasted for about a year before things went back to the "new business as usual." So most of the thinking in Dodd-Frank was to close the most obvious loopholes.

To me, it seems that the theoretical ideal situation is to create a paradigm whereby everyone has the same arbitrage advantage and that the key then for the quants, scientists, mathematicians and policy makers is to find out what the constraints are for each entity in order to satisfy the system-wide arbitrage properties for each individual entity.

That's not going to work. The type of society that you have in mind is an "equal opportunity" system which is very popular in the United States. Americans tend to think that the idea society is one in which "all men are created equal" and in which people "compete" in a social Darwinist environment which is something that fits in the framework of markets.

The trouble with that is that people in other parts of the world have different conceptions of the ideal society. People in the United Kingdom are far more comfortable with the idea that some people just have more stuff because of who their parents are (like Queen Elizabeth II). In this view, people are inherently unequal, but it's the responsibility of the people in the privileged upper classes to help the people in the lower classes.

Now that's just between two English-speaking societies with a shared history. If you bring in the Saudis and the Chinese, then you are just not going to end up with much in the way of shared goals.

The one goal that everyone that matters seems to share is to prevent another global economic crisis, since that benefits no one that matters.

I remember in my financial calculus course how it was described that when the BS equation came, it was something both sides could agree upon.

Not really. It's not a matter of agreement. It's a matter that if the price of an options doesn't obey certain constraints, it's possible to do certain transactions that make money and push the price back to an equilibrium value.

The other thing is that the original formulation of Black-Scholes is wrong and stopped working in 1987.

I imagine that this discussion with regard to regulatory arbitrage might generate the same kinds of discussions that were happening before the Black-Scholes model.

Well... maybe not...

When a trader talks or thinks about regulatory arbitrage (or any other type of arbitrage) it's usually an the context of figuring something out that he can use to make money. Now if a regulator goes to a trader and says "tell us your deepest, darkest secrets so that we can keep you from making money" that's not going to work.

Now the main direction of the conversation, has been the regulators saying "we don't care if you make money. In fact, we want you to make money. Just help us not blow up the world, because if the world blows up, you are going to be on the street."

There's another important term called "regulatory capture."

Solving a system-wide arbitrage problem or realistically, moving towards a solution would probably help solve a lot of system wide problems in general indirectly.

That problem is too big, and there is not enough time. There was about a year in which you could make basic changes in financial regulation, and if there was something that you didn't want changed, your strategy was to delay things and water things down until people move on to other things. Anything that didn't get fixed in 2009, won't get fixed until the next blow-up.

 

[chiro]

Thanks for all that information: you've got me thinking quite a lot from those comments.

There was one particular thing you said:

The one goal that everyone that matters seems to share is to prevent another global economic crisis, since that benefits no one that matters.

and I think this is the probably the starting point for the regulatory arbitrage discussions to at least be considered, let alone actual real discussion take place.

The things you have highlighted about countries just not agreeing is probably the more critical thing though, because the difficulty is finding common ground and it seems that you have really hit on the key idea of what that common ground is which is "making the world not blow up".

The big concern though is this: if you have the world blow up really bad then you have certain "interests" as you have called them which are waiting to hi-jack the situation.

I really can't see a situation that would strengthen the idea of real discussion unless the majority of people were affected at roughly the same time (like the GFC, but on a slightly more intense scale).

At least when that happens, people will have no way to deny what happens (I don't mean just the quants, the regulators, and the traders and other financial professionals, but basically everyone that transacts in some way which include all the people with an ATM card and some cash).

It sounds like given what you have said, one way of looking at "not making the world blow up but still let each individual sovereign nation state do whatever the hell it wants" is to come with constraints that are as relaxed as possible.

Have you come across in your work any fields, papers, authors: basically anything at all that try and look at the most "relaxed conditions" required for the world to "not blow up, but still let every sovereign nation do whatever the hell they want"?

 

[twofish-quant]

and I think this is the probably the starting point for the regulatory arbitrage discussions to at least be considered, let alone actual real discussion take place.

Conversation is pretty much finished. One good/bad thing about politics is that you don't have infinite amounts of time. You had a window of about a year in which you could get any sort of major changes through, and that window is now closed. Anything fundamental that didn't get done before Dodd-Frank got passed is not going to get done.

The big concern though is this: if you have the world blow up really bad then you have certain "interests" as you have called them which are waiting to hi-jack the situation.

You have many, many different interest groups, and politics involves the interactions of those interest groups. Anyone that isn't organized in an interest group is simply not going to be able to participate in the discussion at a meaningful level.

I really can't see a situation that would strengthen the idea of real discussion unless the majority of people were affected at roughly the same time (like the GFC, but on a slightly more intense scale).

You did have real discussion. The other thing is that this isn't a debating society. The discussions that people had in 2009-2010 were intense, angry, brutal, and scary. One reason that people are unlikely to do something like that again is that one major legislative change is going to burn people out, and people don't have the energy for another round of discussions.

A lot of these sorts of discussions tend up when people figure out how to make truces and compromises, and once you have a truce or compromise between deeply entrenched interest groups, no one really is in a mood to break the truces, because most people are too burned out.

At least when that happens, people will have no way to deny what happens (I don't mean just the quants, the regulators, and the traders and other financial professionals, but basically everyone that transacts in some way which include all the people with an ATM card and some cash).

And that's the last thing that anyone with any sort of political authority wants. The thing that everyone is afraid are angry mobs demanding to know were their money went.

It sounds like given what you have said, one way of looking at "not making the world blow up but still let each individual sovereign nation state do whatever the hell it wants" is to come with constraints that are as relaxed as possible.

It's more complicated than that.

Also, it's not an issue with "sovereign nations." One thing that makes this complicated is the nature of Europe. Europe isn't a nation, but it's also not a random collection of independent sovereign nations either. Different people in Europe want Europe to go in different directions, and everyone is going to use the crisis to push their agendas.

One thing that makes this interesting is that right now the UK has it's own seat at the table. If it joins the Euro (which I can't see happening) then UK loses it's own seat and the person that represents UK interests in Basel is likely to be French or German.

The other thing is that you can't talk about "sovereign country A". You have to talk about specific actors (i.e. US, UK, HK, etc.) Also, you have to recognized that some countries just matter more than others. No one cares what Botswana or Jamaica thinks.

Have you come across in your work any fields, papers, authors: basically anything at all that try and look at the most "relaxed conditions" required for the world to "not blow up, but still let every sovereign nation do whatever the hell they want"?

I think that's at level of abstraction that isn't useful when dealing with international politics. If you are talking about say stock purchasers, you could model each stock purchaser abstractly. You can't easily do that with countries, although people in international relations theory try.

One problem is the problem of agency. When you say "the US wants something"? What does that mean? One thing that you quickly find out when you get into economics is that on some issues, the divisions are cross national.

 

[chiro]

It's more complicated than that.

Also, it's not an issue with "sovereign nations." One thing that makes this complicated is the nature of Europe. Europe isn't a nation, but it's also not a random collection of independent sovereign nations either. Different people in Europe want Europe to go in different directions, and everyone is going to use the crisis to push their agendas.

I've followed some of the news on the Euro and the idea of a potential default by Spain, Italy and Portugul is really a sign that this experiment has not worked out the way it should.

The other this is that Greece shouldn't have joined anyway since they got a "US financial institution" to hide the debt through some kind of currency exchange agreement that blew up so when people talk about the recklessness of the Greeks, they fail to account for this fraudulent conversion of debt to a vanishing act.

You've got all these countries going belly up with Germany benefitting from a cheap Euro for exports. Given that it's been around for only 10 years with the rescue fund being pretty much diminished, I can't see why this would continue for too much longer.

As you said, all the countries want to go their own ways which makes me ask the question why they just don't go back to their own currencies?

While Germany benefits though from their own arrangement (good for exports), it really doesn't make sense for Germany at least currently to not support the Euro, but still demand some kind of bailout so that the German banks don't have to take a hit to their balance sheet (as per the situation of the debts of the other countries).

One thing that makes this interesting is that right now the UK has it's own seat at the table. If it joins the Euro (which I can't see happening) then UK loses it's own seat and the person that represents UK interests in Basel is likely to be French or German.

It wouldn't make sense for the UK to join unless they had some kind of power base, since London's main power-base is finance.

Also as you pointed out before, the game is rigged where the least regulated environments will get the transactions, which reminds me of the re-hypothecation laws talked about by a few financial journalists (and the same ones you have talked about in this thread).

The other thing is that you can't talk about "sovereign country A". You have to talk about specific actors (i.e. US, UK, HK, etc.) Also, you have to recognized that some countries just matter more than others. No one cares what Botswana or Jamaica thinks.

Yeah definitely true and I'm glad you pointed it out: it's only considered when someone has something it needs and banana's aren't really crude barrels of oil or US treasuries.

I think that's at level of abstraction that isn't useful when dealing with international politics. If you are talking about say stock purchasers, you could model each stock purchaser abstractly. You can't easily do that with countries, although people in international relations theory try.

Thanks for the heads up in international theory.

I never wanted to get too abstract in my approach: I wanted to keep it simple as possible because simplicity is easy to understand and it's taken a lot more seriously by most people regardless of where they stand, if they are academic and so on.

The other argument that is spouted is that this is a complex problem, and while this discussion is showing a lot of these complexities, to me complex suggestions and suggestions with bastardized language, waffle jargon, and a lot of redundant metaphors are just going to be ignored and rightly so.

It's not useful talking to politicians, regulators, diplomats, and other people that "get stuff done" in complex terms across the board IMO (regardless of whether they give a stuff or not).

One problem is the problem of agency. When you say "the US wants something"? What does that mean? One thing that you quickly find out when you get into economics is that on some issues, the divisions are cross national.[/QUOTE]

 

[twofish-quant]

I've followed some of the news on the Euro and the idea of a potential default by Spain, Italy and Portugul is really a sign that this experiment has not worked out the way it should.

I think it in fact did work as planned.

One thing that the inventors of the Euro thought to themselves was how do we get the countries united in a way that is pretty much impossible to untie. The solution was to get a single currency. Once you have a single currency then you get yourself in a situation were you have to unite everything else, whether you want to or not.

As you said, all the countries want to go their own ways which makes me ask the question why they just don't go back to their own currencies?

Because they can't. It's a one way ride.

The other argument that is spouted is that this is a complex problem, and while this discussion is showing a lot of these complexities, to me complex suggestions and suggestions with bastardized language, waffle jargon, and a lot of redundant metaphors are just going to be ignored and rightly so.

You have to realize that the job of a politician is to come up with bastardized language and waffle jargon. A lot of getting stuff done in politics is to get people that might in fact hate each other and you on your side. Politicians are experts at playing with language to get this sort of thing done. One other thing is that politicians appeal to the mid-brain. In order to get someone to do something, you can't argue "rationally". At some point you have to trigger some sort of deep emotion that gets them out of their chair. That's at one level of the game.

When you go into writing legislation, then it gets more complicated. Sometimes you want something to be hyper-precise (i.e. two interest groups hate each other negotiate a complex horse trade and want that embedded in the law). Sometimes people want things to be extremely vague (i.e. a situation in which people agree to differ the argument or where the text is going to be interpreted by someone that is considered friendly).

It's not useful talking to politicians, regulators, diplomats, and other people that "get stuff done" in complex terms across the board IMO (regardless of whether they give a stuff or not).

It can be. In any event you have to talk to them in their own language. Or sometimes not. If you just take a politician and put them in an angry crowd screaming at them, they'll take the hint that they have to do something.

 

[chiro]

It sounds like enough people were angry and cared to show these guys that they were furious then things would get done, instead of worrying about all the trivial crap that doesn't mean a thing.

I'd be interested if you knew examples of countries where a majority of the citizens had the balls to get angry to actually tell the politicians that they "give a stuff about what they are doing".

My guess is if you have some countries for citizens that just don't want to take an interest in what is happening (I mean what is really happening) then all the lobbying and other actions are going to be done by a small minority.

So when people start to give a crap about what's happening and when you get lots of real screaming and angry people then things will change: probably something which governments want to minimize.

Kind of funny I guess how everybody is just "praying" that nothing blows up while not many people are actually making efforts or thinking about how things can blow up.

Reminds of the scene in Margin Call: one guy was saying to the junior one that everybody else just hopes that everything will work out. If nothing happened, they'd be called pussies and if something happened that they'd be crucified.

The more I think about what's happening, the more I wonder about the veracity of this statement.

 

[StatGuy2000]

I think it in fact did work as planned.

One thing that the inventors of the Euro thought to themselves was how do we get the countries united in a way that is pretty much impossible to untie. The solution was to get a single currency. Once you have a single currency then you get yourself in a situation were you have to unite everything else, whether you want to or not.



Because they can't. It's a one way ride.

I have to disagree with you here, because if it was really "impossible" for a member of the EU to leave the euro and resume their own currency, then it would not be possible for Greece to be forced or expelled out of the euro for failing to meet its fiscal commitments as a pre-condition for receiving bail-out money from the other EU nations. But that is precisely what is being discussed as a very real possibility since it is increasingly difficult to foresee Greece being able to follow through with the austerity measures imposed by the other EU nations (the "Grexit" scenario, as described in several articles in the Economist, among other sources).

http://www.economist.com/node/21555567

Of course, such a scenario would have major negative consequences for Greece, at least in the short run, and could have potential consequences for the rest of the Eurozone (as identified in the article). But strictly speaking, leaving the euro can be done.