Why Trade? The Social Function of Markets

Amid all of the rhetoric surrounding finance and the 1%, it’s easy to lose sight of the fact that markets do in fact play a vital role in today’s economy.

Because the planet has scarce, or limited, resources, we have to make tradeoffs about what investments we make. When society decides to allow Elon Musk to build battery-powered cars by buying Tesla stock at IPO, we also choose not to give those resources to Volkswagen to work on diesel engines. Finance is the mechanism by which we allocate capital to make these tradeoffs.

A less obvious function of finance is the allocation of risk. When we buy home insurance, we reduce our personal costs should our homes burn down, but also assume tiny portions of the costs of all the homes that do burn down. While it seems obvious that insurance distributes risk, the market has mechanisms to do so as well. When Delta Airlines buys oil futures, it protects itself from the risk that oil prices might rise, forcing it to have to pay more for fuel. It shifts this risk onto the “sellers of insurance,” in this case, the sellers of the oil futures.

It seems relatively clear that finance has a role when we think of insurance, mortgages, and electronic payments.

Public markets are fundamentally a way for groups to raise capital. This is done through two mechanisms: equity and debt.

In the public markets, equity is raised as stock. The company receives money in the Initial Public Offering (IPO), and this “war chest” then allows the company to ramp up sales, make battery powered cars, cheat on blood tests, whatever. The shareholders who bought the equity are entitled to a share of the profits for their investment.

In contrast, debt is raised as bonds, whether those be corporate or government-issued. The corporation or government receives money in the initial issuance of the bonds, and can use that money to do any of the corporate things above, or, in the government’s case, pay Social Security, build nukes, pave roads, etc. The bondholders who bought these bonds are entitled to some cashflow in the future that this bond represents, whether that includes “coupon” interest payments intermittently over the next X years, or just one big repayment at the end.

The need for these initial offerings, then, are exactly to provide projects with capital they need to succeed. All secondary trading, or trading on the markets that take place after these initial offerings, have relatively little effect on the company’s processes (they do affect the cost of raising further capital). However, it’s important that these all trade publicly even after IPO or issuance, and the reason is liquidity.

Not many people would participate in the IPO of a company if, in order to get their payout, they had to hold their share of the company as long as it existed and collect dividends. Similarly, not many people would buy 30-year Treasury issuances if they had to wait 30 years to get most of their money back. The public markets allow these people to get instant liquidity for these investments, selling at a new price that reflects how their investment has moved. In addition, public marketplaces are the pricing mechanism that allow people to realize gains on these investments in most cases. So, even if the later trading doesn’t necessarily directly affect the project that finance was meant to allocate capital to, it’s important that people can easily turn their investments into currency to ensure that the system remains well-lubricated and functions effectively.

Individual consumers and investors have a lot of different needs at different times. Maybe Dennis needs to sell his Apple stock today to pay a speeding ticket, but Vicki, who really wants to buy Apple stock, doesn’t get paid until Friday. How does this trade happen?

Maybe Goldman Sachs needs to sell 100 million dollars worth of Ford right away, but total investor demand at any price is only 60 million dollars because their earnings report just came out, and it wasn’t good. Where does the new price of Ford go?

One of the central roles of trading firms is to provide liquidity. What this means is that trading firms help connect these hard-to-connect trades, whether that be because different parties want different sides of the trade at slightly different times, or because nobody else wants to assume such a large position in Ford. Anybody with a smartphone can go into Robinhood and buy Apple right away for just a penny more than she can sell it for. This is almost entirely thanks to professional traders and their willingness to facilitate trades.

Another major role is to determine price. Ideally, the price of a stock should be related to expectation of future company performance, and the price of a bond should be the expected value of the future cashflows from that bond. That things are priced fairly is important to facilitating investment — why would you buy Facebook stock at IPO for 40 dollars if you knew that in a year the company would be three times as successful, but pricing mechanisms were inefficient and it was very possible Facebook would be trading at 20 dollars anyways? Trading firms formulate opinions about the “fair” value of a security, and either buy or sell it in an attempt to make a profit. If they believe the price is currently below fair, they buy, and if they find price above fair, they sell. This action also inherently pushes the price towards “fair.” This is the pricing mechanism of capitalism, and together with liquidity providing, this ensures that investors can be happy investing in projects and knowing that they will be able to flip out of the market at a fair price when the time comes.

Futures, which are contracts that promise to trade a product at a fixed price at a future date, definitely serve a very clear real world purpose as well! In particular, they allocate the risk of future price movements of certain commodities, such as in the example at the top, where Delta Airlines bought oil futures. (They actually do this, by the way.) By making this trade, usually with a trader on the other side, Delta allocates the risk of rising oil prices to the trader. Delta removes its position to be hurt by an increase in oil prices (which arises naturally from its business model of providing flights).

This ability to allocate pricing risk is key to business planning. For instance, being able to fix the cost of oil and remove the risk of it moving helps Delta plan how many flights to book into the future. As another example, take corn futures. Corn farmers need to know how much corn to produce at the beginning of the planting season, and this is a decision to be made with a cost-benefit analysis. Understanding the benefit, or revenue, depends on predicting what the price of corn will be six to nine months from planting. By removing the risk that corn prices fall, by selling corn futures, the farmer can “lock in” a price of corn and plan according to that price.

Derivatives, on the other hand, are mechanisms that help financial firms control risk. A derivative is basically any kind of contract that pays out certain values to certain parties based on something that happens in the markets. Some derivatives, like interest rate swaps, help protect insurance firms from being exposed to interest rate markets. Some, like options, help hedge funds stay in business when the market crashes. You can think of most derivatives as mechanisms that protect financial firms from unplanned future events, and stabilize the markets by doing so.

Let’s not pretend that finance is perfect. Most people don’t go into it with the intention of nobly allocating capital and doing all of the above, and to be honest, if they did, the system probably wouldn’t really work. 2007 was a mistake; incentives weren’t properly aligned, and risk wasn’t really properly measured. It culminated in a housing bubble, and then a crash that left many people unemployed or out of homes. Mistakes in the system are not that unusual — bubbles have popped up all across history (see: NASDAQ in 2000), and it’s important that we work to make them less likely.

The solution, though, when faced with an imperfect system is not to throw out the system all together. We could cap leverage, align incentives, and do a better job measuring and regulating risk. These are all very hard things to do, and smart people are working on these problems. Figuring out how to improve our financial system is productive. What is not is throwing up our hands and screaming that Wall Street is evil.

That’s true, and it’s problematic. But blaming Wall Street is, again, not productive. We should be having conversations about compensation, living wages, progressive taxation, employment policy, food stamps, public spending, racism, sexism, and yes, basic income.

In addition, we should remember that traders often give large amounts to charitable causes. This isn’t a “get out of jail” card by any means, but it’s definitely worth noting. Paul Tudor Jones started Robin Hood (the foundation working to end poverty in NYC, not the mobile brokerage), George Soros has founded the Open Society Foundation, and many traders subscribe to the idea of effective altruism.

Finance is a really important component of the modern economy — the cornerstone of how we approach production as a society today. Nobody is saying that working in finance is the best way to “change the world.” People aren’t perfect, and there is definitely some market activity that does nothing productive for society. But finance isn’t for nothing either, and it’s not about stealing money from the many to line the pockets of the few. In this era where people refer to working in finance as “selling your soul,” it’s worth remembering that the market is the voting mechanism with which we decide what resources will go to reusable rockets and what will go to diaper fasteners.



cs && econ @ stanford || product && software @ startups || organizer @ hackathons || find me at http://mikeyu.me

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Mike Yu

cs && econ @ stanford || product && software @ startups || organizer @ hackathons || find me at http://mikeyu.me