March 9, 2011
I was wondering the other day why investment banking, which is in theory a competitive service industry, appears to be so insanely profitable. A notion occurred to me, but not being an expert in the field it’s hard for me to evaluate its veracity. It’s got a certain sinister elegance to it, though, and if you’ll bear with me for a minute I just want to put this idea in your head.
The 2001 Nobel Prize in Economics went to Akerlof, Spence, and Stiglitz for their “analyses of markets with asymmetric information“, that is to say, the economic effects of the other guy knowing something you don’t. Akerlof’s classic paper on the subject is The Market For Lemons, of which Wikipedia provides a good summary, per usual. The more cynical among you are rightly saying, well yes, the economic effect of making a deal with somebody who knows way more than you do is that you lose your shirt, but that’s microeconomics; we’re talking macro here. There are no easy buckets on this court.
In any case, one thing I haven’t found in my cursory n00b investigation is something on the economic effect of what I will politely call an asymmetric understanding of the basic principles of modern markets and the naive company’s place in them. Which is to say, let’s imagine… I start like that because from what I can tell, “let’s imagine” is the traditional way of starting any argument about economics. Which probably tells you something about economics, now that I think about it. Seriously, try googling the name of your favorite economist plus “let’s imagine”, and count the Google hits. It’s eerie.
Anyway, you all know what derivatives, specifically futures are, right? The idea is that you can set up a long-term contract to sell a thing at some fixed price, fixing the price and letting the buyer at the other end absorb the risk, reaping the potential benefits or losses of a fluctuating marketplace. This lets our entirely imaginary A-One Flour Co. say “for the next five years we’re selling you this much flour for this price every year”, and whatever happens to the market price of flour, either more profit or unexpected loss, get absorbed by whoever’s on the other side of that futures contract.
That, in short, is why futures are traded – there’s both risk and potential profit involved, ownership can change, etcetera. But our imagined A-One Flour, a company with one major input of “wheat” and a single output of “flour” may choose to engage in the same sort of transaction on the wheat-purchasing end, to give themselves some stability on the supply side as well, a sensible move now that there’s a lot less flexibility available to them in terms of revenue. So they agree to buy a fixed amount of wheat for a fixed price over the course of the next few years, from some commodities trader whose hope in this case is that the cost of wheat will drop, thus insuring him some profit on the deal.
Now let’s say I’ve been watching all this, or more realistically I’ve had my computers watching all this. I see what the A-One people are up to, and because they’re traded commodities and I can, I buy both of those futures contracts.
Now: what just happened to A-One flour? They no longer control, in very real sense, the amount of money coming in, the amount of money going out, or who they buy from or sell to. They get wheat from me, they sell flour to me, and they’ve effectively been reduced from controlling their destiny to little more than operating their machinery. They went looking for stability, effectively trading stability for control. I own the complete set, in the Boardwalk & Park Place sense, of contracts for their material, and thus financial, inputs and outputs and this effectively means that I’m the one who’s really in charge of the company. All that without a single share of A-One Flour changing hands.
Better still, if I can pull the same trick with B-One Bread Co., and pair up those futures contracts profitably? That’s a pipe that spews money. And maybe even better than that, this is de-facto inside information about how profitable (or not!) A-One is going to be in the next year or three. So I have this great arms-length way to engage in what would normally be insider trading, knowing what’s going to happen to A-One long before shareholders or the public does. And it’s an oversimplified example, sure, but I’d be surprised if it wasn’t already a well-understood process in some of the taller office buildings of the world.
I haven’t thought of a better way to make money recently, but I’ll let you know if I do.