Future of Finance Ⅱ
〜The World of Web 3.0 as Seen by a Former Hedge Fund Portfolio Manager and Goldman Sachs Currency Trader
This story is a continuation of Future of Finance I, Chapter 1: A Modern History of Financial Institutions — Changes Induced by the Once-in-a-Century Crisis
Chapter 2: Information Asymmetry: The Merits and Drawbacks of Centralized Finance
At its core, finance is a service industry. Rather than making, selling, or transporting goods, it provides services to customers in exchange for fees. In human terms, we could say that it plays the role of a pump or heart that turns the blood. Of course, Banks can’t survive by earning interest from deposits and loans alone, so they engage in a wide range of other activities, including research, proprietary trading, M&A, and providing advisory services.
So why have they been so profitable? One reason is ‘information asymmetry’.
Alchemy
As mentioned in my previous post, the early 2000s was a period of global economic stagnation, causing the US Federal Reserve to gradually lower interest rates. Investors were struggling with low returns and were thirsty for products that could yield high-interest rates. To fill the demand, securities companies introduced a series of financial ‘derivatives’.
Most people do not buy an expensive jar if a psychic medium offers it because they can tell at a glance that it is a scam. On the other hand, people buy new financial products created by mathematicians and the contents of which are unknown, because they sound good and seem to be profitable. A good example is the investment trust called Phony Dividend, which was popular in Japan for a while. It is easy to misunderstand that you are making a profit because you are receiving high dividends, but when you open the lid, you will find that you are actually just withdrawing money from the fund that you paid for.
There are wide range of derivative products, and there are countless products that are suitable for customers and provide a win-win situation for both parties. In fact, most were originally created based on such ideas. At the same time, however, it is easy to imagine that there were cases where the contents of these structured products were not readily apparent, or where they were sold without sufficient explanation of the risks involved. This is because when working for a financial institution in the middle of capitalism, if you cannot make a profit, you are considered redundant and replaced without hesitation. As a result, the salespeople at Wall Street firms tended to be motivated by short-term profits.
A Wave of Government Intervention and Regulation
If the global financial crisis resulted from letting capitalism run wild and unchecked, then Adam Smith’s theory of the invisible hand of the economy doesn't hold true. The auto-adjustment function was not viable, and it produced a large number of unemployed people. And history repeats itself. After the collapse of the bubble economy, there was no hope of a quick recovery without government intervention or stimulus.
Faced with a once-in-a-century financial crisis, the world’s central banks injected massive capital in rapid succession to rescue financial institutions and create a safety net. At the same time, they increased public works projects to support the economy. Thanks to these efforts, the world gradually recovered. The government investigated the causes of the crisis and tightened financial regulations to prevent a recurrence. They set stricter capital adequacy ratios and information disclosure requirements for financial institutions, additional liquidity requirements, annual stress tests, etc. The tightening of regulations escalated year after year with the support of the public opinion. In particular, the requirements for the U.S. group of banks known as GSIBs (Global Systemically Important Banks) were incredibly stringent. For those of us who have worked in the field, the excessive escalation of regulations has led to frequent situations where liquidity among banks has dried up, which has ironically harmed customers.
Incidentally, the central bank’s swift and effective response to the Covid crisis in March 2020 was probably due to its experience with the Global Financial Crisis.
A New Scandal
I mentioned earlier the ‘information asymmetry’. The point is that whether you know it or not, in other words, the contents are appropriately disclosed, and the risks are understood correctly.
The regulators have been investigating the past transaction records of the financial institutions and imposing fines on them one after another. One of the things that came to light as part of this process was the alleged rigging of ‘LIBOR’, which was broadly used as an international benchmark interest rate. To put it simply, some banks had colluded to arbitrarily set the benchmark interest rate to make money for the banks, which was an unbecoming incident. In the end, LIBOR and the rate-setting process administered by the banks were replaced with a new benchmark rate at the end of 2021.
After the collapse of Lehman Brothers, regulations and supervision became stricter and stricter, and as a result, financial institutions whose past misdeeds had come to light came under increased scrutiny. As I mentioned in my prior article, the spread of the Internet and the widening wealth gap combined to create hatred that grew into the ‘Occupy Wall Street’ movement.
Change of Direction
Goldman Sachs, where I worked, was no exception. A series of lawsuits, fines, and stiff settlements put pressure on earnings and caused the company to gradually cut its workforce. Even after the economy bottomed out, the markets division never regained its old glory. The annual end-of-the-year parties were no longer held. In the markets sector, staffing and costs were steadily reduced, and the industry as a whole saw a significant reduction in the risk tolerance of market makers.
On the other hand, there were two departments that were accelerating the hiring process. One is ‘the compliance’ division, and the other is ‘the technology’ division. In 2017, it was reported that the ratio of engineers in the company had reached one in four.
