Crises

Crises are moments of inflection that challenge our understanding of the future. The prism of our daily lives blurs the line between the past and the present, making most changes imperceptible. A crisis, however, is a sudden shock that causes us to re-evaluate our expectations of the future and reshapes the way we think.

This year marked the centennial of the World War I Christmas Truce, when British and German soldiers crossed the trenches and exchanged Christmas greetings. It is a symbolic gesture that lives on because WWI was one of the most violent wars in human history. The intensity of the fighting shocked not only the soldiers, but also the military commanders of the era as well. In 1914, the strategy of war had not kept pace with technological changes in warfare. The textbook shock tactic officers learned in military academy was a full-frontal cavalry charge, which was ineffective against machine guns. Politicians viewed war as an instrument that could be used for limited ends to settle disputes between nations. At the outbreak of hostilities, observers at the time predicted a ‘summer war’ that would punish Serbia for the assassination of the Archduke. Few people understood that the nature of warfare had changed and that overlapping military alliances posed a systemic risk that could draw all of the great powers into a total war, where the unconditional defeat of either side would be the only possible resolution. Politics was thrown into crisis. As war rippled across the entire continent with staggering casualties, the stakes of the war multiplied. The mantra that emerged from World War I was that it was a ‘war to end all wars.’

The Bailout to End All Bailouts #

Like politics, finance is an attempt to rationalize an inherently unpredictable system. In politics, there is no guarantee that the laws governing human relations, negotiated through millennia of struggle, will survive in the same state forever. Similarly, there is very little reason to believe that our financial system will remain the same either.

The price of a financial asset represents the synthesis of disparate information into a single reference point: the price. This measure is mostly stable and self-regulating because the market is very good at absorbing new information. However, a sudden disruption in the functioning of the market can occur when the market’s feedback loop breaks, revealing flaws in the methodology used to price assets or in the structure of the market itself. When this happens, the survival of the market is called into question, causing a financial crisis. Although the signs of an impending crisis can be seen in retrospect, they are difficult to observe ex ante because they are obfuscated by the noise of normal fluctuations in asset prices.

In 2008, a financial crisis caused huge dislocations in asset prices worldwide. Like the outbreak of WWI, which started as a conflict between Austria and Serbia and escalated into a total war, the financial crisis started with a meltdown of the mortgage market and subsequently threatened the survival of the banking system. The Federal Reserve and the US Treasury were not prepared to deal with the systemic problems revealed by the crisis. They had to improvise the actions they would take to restore balance to the financial system, making up the rules on-the-fly. After several different approaches failed to stem the crisis, the severity of the situation became apparent, and bailing out the banks became the only option under serious consideration.

“The exception is more interesting than the rule. The rule proves nothing; the exception proves everything. In the exception, the power of real life breaks through the crust of a mechanism that has become torpid by repetition.” - Carl Schmidt

We should examine why, when put to the test, the government was forced to make an exception to the rules and bail out the banks. Individuals and firms make decisions about the future with the understanding that the rules of our financial system are universal and cannot be circumvented. Revisions to these rules should, at the very least, occur after serious discussion and through a democratic procedure. The bailouts prove that a critical principle of fairness in the financial system is unenforceable. If the only way to resolve a financial crisis is through a bailout, isn’t that what the rule was all along?

House Advantages #

Technology has fundamentally changed finance, linking the prices of assets to a world marketplace that is not subject to oversight by a single authority. Electronic markets allow for vast amounts of information to be collated and distributed at near zero cost, enabling anyone in the world to trade financial assets with anyone else. Despite this capacity, the vast potential of electronic markets is untapped. Many of the most important assets in the world, including the mortgage securities that ‘caused’ the financial crisis, are currently traded over-the-counter. That is, transactions are negotiated and recorded only between the two parties to a trade (typically, a bank and its customer). When transactions take place over-the-counter, the market is deprived of valuable information, which could otherwise be absorbed into prices. This results in higher execution costs paid by investors and less transparency for regulators.

Even worse, over-the-counter trading contributes to banks becoming too big to fail. Each bilateral transaction that a bank executes becomes a private piece of information that can’t be used by a potential competitor. A bank that is able to accumulate a critical mass of bilateral transactions in a particular market is able to establish a private feedback loop, giving it an advantage over the market.

The capital markets are a worldwide public good. A bank shouldn’t be guaranteed a perpetual ‘house advantage’ for being too big to fail. The market should be an impartial source of information. The more information that is recorded by the market, the more likely it is that the market will be able to successfully regulate itself, averting a crisis that undermines faith in the financial system.

Blame #

In the aftermath of World War I, the blame for starting the war fell squarely on the central powers. The allies demanded that Germany, which was the only solvent defeated country, pay reparations to the allies. The reparations were designed to make the European public feel that Germany was being punished for starting the war. This settlement turned out to be a complete failure. Within one generation, the conflict was rekindled and another senseless war ensued.

A bank that is too big to fail isn’t a threat that can be fined out of existence. The US Justice Department has slapped billions of dollars in fines on banks that mis-sold mortgage securities, but those same franchises still dominate over-the-counter trading. In the past few years, regulators have uncovered illegal trading schemes in Libor (which benchmarks $650trln of interest rates derivatives) and in the $4trln/day FX market. Recently, the New York Department of Financial Services announced that it was exploring whether the trading code used by Deutsche Bank and Barclays in their dark pools violated the law.

The beneficiaries of the current financial system want to hold on to their special privileges, and so far, we are appeasing them. There’s no need for regulators to start hiring programmers to comb through lines of code. A financial system that is constructed on just and equitable principles of trade is self-regulating. Banks have spent millions perfecting ‘dark pools’ that are designed to remove information from the market. There’s a simple way to neutralize them: require trading venues to publish all quotes and trades.

Markets naturally shun complexity. When different protocols for trading are forced to compete on equal terms, the complex ones disappear. A stock argument used to justify the existence of dark pools is that they represent ‘alternative liquidity’ for investors. Indeed this ‘alternative’ marketplace is only offered to investors under the condition that trading information not be disclosed to anyone except the bank! In other words, private trading venues wouldn’t exist if they had to compete with public markets.

Direct Match #

At Direct Match, we are building an open marketplace for US Treasuries. The marketable debt of the US Government represents $12.4trln of the world’s wealth and is also the anchor for interest rates on corporate bonds, mortgages, and many other asset classes. We believe that making electronic markets more competitive will be beneficial to investors in US Treasuries as well as other related asset classes.

We also believe that creating a fair market for US Treasuries will be a step towards making our financial system more resilient against shocks. By introducing a new paradigm for a critical over-the-counter market, we will have brought financial markets closer to an ideal state in which trading information is no longer the closely-held property of powerful interests.