Alchemy is not a good core strategy in financial services.

Last September I was asked to give a presentation at the DerivaTech conference in London on the merits of derivative markets. My basic premise was that derivatives are (just) tools: they can be incredibly useful and are not intrinsically ‘good’ or ‘bad’ but rather their utility (or danger to society) depends on how they are used. You can use a hammer to build a house. Or you can use it to bash someone’s head in. Getting rid of hammers because of this undesirable use case obviously wouldn’t make too much sense.

Further, I made the case that the industry had done itself an enormous disservice by “using the hammer” in the “wrong” way – by (deliberately) exploiting the ability of derivatives to obfuscate, the industry had not only ended up losing hundreds of billions but had done a great job in destroying perhaps its single most important core value creator. That of course would be trust. And in the bargain all the beneficial uses of derivatives risked being thrown out with the proverbial bath water.

Basically, as their traditional businesses and cash cows – agency trading, underwriting, etc. – had their margins melt and their business models / compensation structures made obsolete by the rise of the networked information economy (destroying information scarcity which lay at the core of the traditional banking business model), the banks turned more and more to principal risk taking – prop trading, derivatives ‘arbitrage’, etc. – to make up the difference. Putting aside the moral hazard (too big to fail, insured deposits etc.) issues this raised and ignoring for a moment whether or not it is an intrinsically good business model for a bank, it got worse as this shift coincided with a long period of low volatility and benign economic growth… This meant that the (real) opportunities disappeared quickly and – still needing to shore up the bottom line, to feed the blue line – what had started out as science slowly but surely slid into alchemy…

Of course this didn’t happen overnight, but slowly and therein lay the heightened danger: like the apocryphal frog boiling in a slowly heating pot, what started out as useful and reasonable ended up dangerous and irresponsible.

It strikes me that the whole Madoff affair was in fact a particularly acute and egregious manifestation of this phenomenon. I was reminded of this by Andy Kessler’s excellent analysis in Forbes:

My guess is that this is what went down. Even though Madoff Securities was on the leading edge of automated trading, the business itself was becoming less and less lucrative. Everyone had the same computers. Spreads, the difference between the bid price and the ask price that became Wall Street trading profits, began shrinking. And the move to list stocks in penny increments instead of eighths (12.5 cents) whacked trading desks all over Wall Street.

So you make it up in volume. Beyond cocktail parties, Madoff really created the money management business to feed himself trades. But his strategy was garbage. He absolutely bombed as a money manager, but he desperately needed the assets under management to feed his trading operations, so he started to make the numbers up. As is usually the case, most don’t set out to be crooks, but Madoff became one when his talents proved lacking. There is your “why.”

It’s not new. This was the Enron story: They lost tons in water ventures and Indian power plants, so concocted fraudulent entities to cover up their losses. Same for Sam Israel and his Bayou hedge fund. And even (without the fraud) the Citigroup/Wall Street story, too. They tried to be investors to make up the difference of their bread-and-butter business deteriorating and were awful at it, so they levered up in off-balance-sheet vehicles.

So why are smart people seduced into these kind of strategies (ie bloody-mindedly pursuing disappearing returns to the point of destruction)? Obviously any trite answer on a blog post will fail miserably to do justice to this question, but if I had to venture a pithy hypothesis, it would be that – like it or not – most people are wired to prefer risking conventional failure over embracing unconventional success. Just ask the behavioral finance guys…I think it has something to do with continuing to dance.

So I can get my head around a ‘Madoff’ happening. What is harder to understand is what on earth the fund-of-funds who invested so much money with him were thinking? I may be obtuse, but I thought the main (the only?) reason for these businesses to exist was in order to identify, understand and monitor good investment managers. On this I have to say I agree with Martin on this (that financial companies who made money selling Madoff products should return their commissions.) And it is worth pointing out that regulators haven’t exactly covered themselves in glory either (which should be a cautionary tale for those who suggest that regulation is a panacea…)

Perhaps the only good thing to come out of all of this is that the cult of secrecy that for too long permeated finance will disappear. Don’t misunderstand me, there is a time and place for confidentiality. But too often it is indiscriminately invoked like some sort of fantastical talisman – out of all proportion and context – to hide not skill but incompetence.

And to end on a more optimistic note, the problem is with the ‘traditional’ (ie 19th/20th) business models in finance, not finance itself. And here at the dawn of the 21st century there is an abundance of opportunity to discover, invent and build the financial services industry of the future. This hasn’t changed in 2008. It just became a bit more likely to happen sooner rather than later. Remember the wise words of William Gibson:

The future is already here – it is just unevenly distributed.

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