May 10, 2019 Reading Time: 6 minutes
Tomb of Giuliano de Medici and below lying on the sarcophagus Michelangelo’s sculptures ‘Night and Day’

I previously discussed the phenomenon of selling property that one does not own. Besides the “Fractional-reserve banking is fraud” idea, I mentioned a left-wing variety, founded in a hostility towards societal interactions done in markets. Financial markets, as always, are particularly hit by such notions, always denounced as bringing out the worst traits of humankind. This type of attack dates back to the very beginnings of modern commercial finance half a millennium ago.

Examples abound where left-wing proponents question the social value of some financial instrument or call for entire categories of assets to be abolished (here, here, here, or here). Admittedly, most informed and civilized debate over the social value of financial markets quickly reaches a strange divide; there are “good” kinds of financial products — and those may be responsibly used — and then there are “bad” kinds — which should be banned or strictly regulated.

Let’s have Eric Posner and Glen Weyl, recently noticed for one of last year’s most provocative econ books, Radical Markets, explain the duality:

An oil producer faces the risk that oil prices will fall while a consumer faces the risk that they will rise. The producer and the consumer might use a futures contract to hedge this risk by contracting to transact in the future at a price fixed today, thereby effectively purchasing insurance against the risks they both face. The consumer no longer worries that a price increase will interfere with his daily commute, while the producer no longer fears that a price decline will force him to lay off his workforce. This insurance reduces the unpredictability of the individuals’ incomes, smoothing them out across different contingencies. Such transactions embody the valuable spreading of risk for which financial markets are justly praised.

This is a very straightforward exposition of how futures markets may benefit both parties to a trade, in a form that even most first-year business students grasp. So far, so good — if this were all that financial markets did, who could object?

Now, Posner and Weyl move on to the “bad” kind of finance, where individuals do not use market contracts as insurance for their own underlying business or consumption needs:

Consider an alternative scenario. Suppose that two individuals, neither of whom uses or produces oil, harbor different opinions about the future price of oil and decide to wager on it. Both parties willingly participate, because they think they’re each getting the best of their confused counterparty.

In contrast to the insurance-like example above, both cannot gain; one trader will “win” and another will “lose” since the future direction of oil prices can only make profits for one of them. This looks much more like the gambling activity of a casino than the sound, actuarial planning done through insurance contracts. Indeed, Posner and Weyl conclude, “this sort of speculation is socially harmful.”

Here’s the thing. While the “good kind” of financial trade seems extensive, it only works in very narrow forms. What happens if there are more oil producers wanting to lock up future prices than consumers? What if they have many different prices or time frames in mind? To finance skeptics, these pesky decentralized details play no part.

Financial contracts — actually even insurance — are “complete,” in the sense that somebody always carries the risk. For an oil producer looking to lock in a certain quantity of oil at a particular price at a particular time, “good kinds”-only trades would be blunt ways to hedge only limited risks. Much less rearranging of risks could take place, and individual agents would be left holding more specific risks than they are comfortable with.

Luckily, schemes like Posner and Weyl’s don’t run the show. Precisely because there are “bad kind” financial actors out there who are willing to take on risk unrelated to their own business, they move market prices and aggregate information about the world so that those of us without such information may still benefit. The dichotomy stated, where one party wins and the other necessarily loses, completely miss the point of what markets do — remarkably so in financial markets. All of us have different risk tolerance, different goals, different time frames, and different consumption needs.

Imagine somebody concerned about future oil prices. To protect against price fluctuations, he might buy a financial instrument that locks in current prices, with the intended goal of eliminating the volatility, the uncertainty, or his total risk — risk that may stem from his own consumption plans. Even if market prices move against him, such that his counterparty “won” and he “lost” in Posner and Weyl’s simplified view, the benefit from eliminating uncertainty was still valuable to him. Sure, without locking in prices, he could have benefitted even more by lowering his total oil costs — but that would have meant enduring the devastating risk of market prices moving the other way as well as bearing the uncertainty of what might happen.

On an individual basis this is starting to look a lot like insurance — or any other kind of market. But for it to work effectively and offer as much protection for the countless needs of millions of our economy’s participants, we cannot limit financial markets to only the “good kind” of trades.

Dutch East India Company

Let me make another illustration using some fascinating financial history from the world’s first stock exchange. Following the establishment of and trade in Dutch East India Company (VOC) shares, both a thriving stock market in VOC shares and derivatives trades emerged in Amsterdam. One prominent merchant, Hans Thijs, started using VOC shares as collateral for loans so that he could rapidly expand his own operations. By offering collateral — a common practice even today — Thijs provided his creditors with more safety than simply trusting their assessment of his ability to repay (and probability of repaying). In case Thijs defaulted, the creditors at least walked away with whatever was used as collateral.

Now, while Amsterdam and later London were the most financially savvy places of centuries past, their financial markets were much smaller and much less extensive than today — only a few select assets were frequently traded and had their prices widely advertised. Taking advantage of this transparency, Thijs offered up his VOC shares as collateral rather than the hard-to-transfer municipal debt that were otherwise used. Now lenders could instantly assess the value of the collateral — the VOC share prices were printed in most newspapers — and monitor it throughout the loan period.

However, VOC share prices could fluctuate quite a bit, and would thus offer very different levels of protection for a creditor. Should the share prices fall too much, creditors would be taking much larger risks than intended. Importantly, share-pricing risk might be a very different business than assessing Thijs’ creditworthiness; a prudent decision would have been to decline to lend, and leave the mutual gains from trade unrealized.

Instead, Thijs’ creditors took to the emerging derivatives market and bought put options on the VOC shares. A put option allows — but does not require — the holder to sell an asset at a particular price at a particular future time, ensuring that Thijs’ creditors could sell the VOC shares pledged as collateral at sufficiently high prices in the event that Thijs defaulted on his loans — a financial-market insurance policy, in other words.

There are at least two take-aways from this elaborate expedition to 17th-century Amsterdam. First, somebody had to sell put options to Thijs’ creditors. That is, somebody else had to carry the risk they were unwilling to carry. Risks don’t disappear; they are simply rearranged. The new holder, akin to insurance companies, could have been much better informed about the VOC’s trading business or the likely share price further down the line. As such, they might have been willing to take on that risk in exchange for the initial cost of the options — irrespective of their underlying professional exposure to VOC, as the “good kind” of financial schemes would prescribe.

Second, Thijs’ creditors acquired a contractual right to sell something that they did not own. Indeed, the only reason they bought those options was to protect themselves against the unlikely event that they would own VOC shares after Thijs defaulted.

Under the “good kind”-finance assumption, these trades could not be made and Thijs’ productive investments would not take place.

Financial markets, including markets for complex instruments that may just look like speculative casino bets, allow important real transactions to occur. And in a brilliantly decentralized way, they bring into harmony people whose information, values, goals, and risk aversion differ.

Joakim Book

Joakim Book

Joakim Book is a writer, researcher and editor on all things money, finance and financial history. He holds a masters degree from the University of Oxford and has been a visiting scholar at the American Institute for Economic Research in 2018 and 2019.

His work has been featured in the Financial Times, FT Alphaville, Neue Zürcher Zeitung, Svenska Dagbladet, Zero Hedge, The Property Chronicle and many other outlets. He is a regular contributor and co-founder of the Swedish liberty site Cospaia.se, and a frequent writer at CapXNotesOnLiberty, and HumanProgress.org.

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