Financial Innovation and Complexity

Mon, Apr 2, 2012 | Jared Woodard

Strategy

It’s become really popular in the financial media to rail against the complexity of financial products. For products offered to the public, those complaints seem justified. Mortgages are too complicated and trap-laden, in some versions, and the “vanilla product” idea championed by Elizabeth Warren for the CFPB seemed like a winner to me. On the investing side, the TVIX saga is just another example of why ETPs whose sole purpose is to offer access to more leverage should never have received regulatory approval in the first place: investors who can’t get leverage in some cheaper, easier way shouldn’t have that leverage at all.

However, complexity in the service of truth is no vice. One of my favorite metaphors for financial products is that they are like languages. If I ever write a book, it might be on this theme. Delta one products are like the speech of a two-year-old: yes, no, long, short. Add in options, and credit, and other products, and suddenly you can say a whole lot more. And since most market participants have more interesting views than just “rates are going up” or “the S&P 500 is going down,” it makes sense for them to use products that let them express those views more precisely. Here’s a perfect example of what I mean, from David Murphy’s under-followed Deus Ex Macchiato blog:

The 2011 macro conviction trades were:

1. Eurozone fears are overdone. Many market participants are in my view overestimating the likelihood of Eurozone breakup, especially in the short to medium term. Long the Spain/Germany spread. Result. It made money on an accrual basis, but the P/L volatility on a mark to market basis was ugly. Score 1/2.

2. The developed equity markets are overbought. They are likely to continue that way for some time, so I like selling 3 or 4 year slightly out of the money calls on the Eurostoxx and SPX. Result. The Eurostoxx trade, the SPX one (so far) didn’t. Score 1/2.

3. Japan might finally get its act together. OK, perhaps not that likely, but a medium sized punt on the Nikkei feels like reasonable value. Expect yen appreciation, though, so you might want to currency-protect that. Result. Underwater, but not by too much. Score 1/2 mainly for calling the currency right.

There are a couple other ideas that also prove my point if you click through. And my point, again, is that none of the theses he expresses would be tradeable without some correspondingly complex products. The philosopher of science Nancy Cartwright argues that there is a tradeoff between the simplicity of a proposition and its accuracy. The more accurately a proposition (expressed as a trade, or spoken as a sentence) represents and explains the world, the more complex the proposition will be, because the world is complex. The trouble is that it’s hard to understand complex things, so we reduce the world to laws of nature and P/E ratios and moving averages in order to get some epistemic traction. We give up some accuracy so that we can make at least a little progress. When it comes to choosing theories, scientific or otherwise, balancing simplicity and explanatory power is pretty tricky.

The way this figures back in to the regulation of financial products is that plain vanilla products offer the simplicity that is appropriate for retail customers. The average investor doesn’t need to say anything about monetary policy on other continents. For those who do, financial innovation makes it possible to represent the world more accurately.

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1 Comments For This Post

  1. mutant_dog Says:

    Well, Jared, yes and no. Yes, it is wonderful that one can construct a nuanced position using and managing multiple instruments. However, one should never buy a nuanced construct from one counterparty; each of the variables will carry their individual full price, and consequently, one will receive notably poor value. (Plus, it is by doing “bespoke” multi-variate trades that one becomes known as a “muppet” – and nobody wants that.)

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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