Finance, the Business of Friction

Not long ago, Mike at Rortybomb had an interesting series of posts considering the appropriate size and scope for the financial industry. He made an interesting point — that in a perfectly frictionless market, there shouldn’t be a financial industry. Willing lenders should lend directly to borrowers. In a sense, the farther we get from that ideal, the more inefficiency we’re dealing with.

In practice, we’ll never be able to eliminate the need for finance. There are many practical difficulties connecting lenders with borrowers, and financial institutions have arisen to help address them. They’re there to reduce transaction costs, to provide information, and to help lenders and borrowers manage risk and uncertainty. And they’re clearly doing a bang-up job. When we think about the value of recent financial innovations, it’s worth considering how they contributed to the ways in which financial firms handled the above tasks. Have transaction costs been reduced? In some cases, the answer is clearly no, while in others they answer is yes, but at the expense of the latter two functions. Have firms become better at obtaining, understanding, and providing information? To the contrary, firms seem to have primarily tried (and failed) to create products that made information gathering unnecessary. And for the most part, firms seem to have magnificently misunderstood the effect of their decisions, individual and in aggregate, on the stability of the financial system.

Frankly, I have no idea what most of the recent growth in finance was for. There seems to have been a simply remarkable amount of waste. Consider this, from a recent Felix post on a potential Ponzi scheme:

The one thing which is abundantly clear is that Jeffry Schneider (always mistrust people who can’t spell their own name) is a very shady character indeed, who was fired from various financial-sector jobs before ending up selling fraudulent hedge funds and seemingly working out of the Bidens’ hedge-fund hotel. Schneider was a “marketer” for hedge funds, including Ponta Negra — which means he sold them to rich individuals, and took a commission for so doing. How did he find the rich individuals? Lots of ways, but one was that he paid upwards of $10,000 a month for access to lists of people who were rich enough to qualify as hedge-fund investors.

Now this case obviously involves some lawbreaking, but still. You have some people engaged in assembling lists of rich people, which they then sell. You have others buying these lists and using them to try and get people to invest in various funds. And then you have the funds themselves, and as we learned from the Madoff case, a lot of people out there were paying managers two and twenty only to have those managers turn around and dump the money in some other fund. How many middlemen are involved here?

To get back to Mike’s original point, when you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.


  1. Doug says:

    A proposed index: As financieres approach athletes in terms of name recognition and the dreams of 8-year-olds, the closer we are to cash-in-the-mattress time. And swine flu, probably.

  2. Karl Smith says:

    “in a perfectly frictionless market, there shouldn’t be a financial industry”

    This doesn’t seem right to me. If we are thinking about an economy with money then we are thinking about an economy with liquidity demand.

    If the economy is frictionless in the sense that all trades are settled by a grand world wide auction in which goods are exchanged directly for goods then of course we don’t need finance. However, short of that we need liquidity.

    Part of the service of the financial industry is to supply that liquidity. That is, the current economy functions as if there was far more money (however you choose to measure it) than the size of the monetary base.

    Unless liquidity demand is zero, there will always be an incentive to lend long and borrow short. The needs of ultimate borrowers and the needs of ultimate lenders are fundamentally misaligned.

    Its not simply that they cannot write perfectly enforceable contracts under perfect information.

  3. Phil says:

    What sort of barriers to entry are there for the hedge fund business. Isn’t the reason people can make fabulous amounts of money in this business really because there aren’t that many people in the business.

  4. Karl Smith says:

    Phil –

    It seems likely that education, not just how much but where, and intelligence are probably strong limiting factors.

    The education part is in part necessary because there are some things it would be nice for you to know, but perhaps more importantly because it reduces networking costs – there are some people who it would be nice for you to know.

    Also, it might seem strange to continue to cite the intelligence of hedge fund managers after their dismal performance last year and their role in the bringing about the whole crisis.

    However, I think we are seeing the results of misaligned incentives more than foolish behavior. If you have 20% of the upside and little to none of the downside, it makes sense to take on larger and larger amounts of risk.

    It is easy to forget that losses are always bounded. You can’t loose more than you have and in most real world situations you can’t even really loose all of that. Many actors can at most be fired.

    This creates a natural bias towards over leveraging. It seems strange to me that so many both inside and outside of finance seemed to think that self-regulation was enough to mitigate systemic risk.

    All of the small biases compound upon each other to create enormous bias.

  5. Aron says:

    Very well stated!

  6. Tom Dawson says:

    We have had examples of Lenders in the UK dealing straight with the borrower. OK , they save on commissions that would have been paid to an intermediary, but the inherent problems of lending to people that they should not have been lending to still remained. So much so, that due to a huge bow-wave of impending financial claims against mis-sold financial insurance products, one Company owned by one of the Big Four banks, closed it’s doors to avoid the issue. You might move where the money is made, but you do not remove the problems, you just relocate them.