“Complexity is like energy. It cannot be created or destroyed, only moved somewhere else. As a product or service becomes easier for users, engineers and designers have to work harder. [Donald A.] Norman writes: “For example, the files and folders conceptual model for computer interfaces does not change the way files are stored, but by putting in extra work to translate the process into something recognizable, designers make it easier for users to navigate .” —Shane Parrish,
Fitch Ratings’ downgrade of U.S. Treasury bonds from AAA to AA+ last week points to a latent principal-agent problem in modern financial markets: investors have outsourced a big a part of their risk management to the rating agencies.
But the issue goes beyond pure risk management and rating agencies.
Before Standard & Poor’s downgraded the US credit standing in 2011, financial contracts known as “risk-free” or liquid assets as AAA-rated securities. These assets were considered “good collateral” and were a requirement in most financial transactions.
When US bonds received a split rating, the chance of forced liquidation of US Treasuries following an additional downgrade became clear and present. As Jim Bianco writes: “Over the next 12 years, most of these financial contracts were rewritten to include “debt secured by the U.S. government” or similar language.”
But the United States’ financial situation has deteriorated over the past decade, which explains why Fitch’s downgrade wasn’t an enormous surprise. True, some disagreed with the choice while others felt it didn’t come soon enough, but most market participants greeted the news with a collective shrug.
A rigorous financial evaluation of U.S. government borrowing ignores the country’s strong geopolitical position. Its enviable geographical location and unique influence on global shipping routes ensure it a outstanding place in the worldwide economy and are crucial aspects in its creditworthiness.
This is the dilemma that Fitch and other rating agencies face once they reduce a phenomenon as complex because the creditworthiness of a sovereign state to a straightforward label. Such labels help keep trading going, but what they really mean is that they change into more opaque and lose their informational value. Before 2011, two rating agencies could initiate deleveraging and trigger a panic in financial markets. But thanks partially to the rewriting of economic contracts lately, Fitch’s decision did not bring about such an event.
This is taken into account a present item. But what in regards to the restorative impact of deleveraging on balance sheets or the fiscal discipline it could bring? What if policymakers needed to be reminded that there are costs to continued debt accumulation? In the past, markets have dictated this discipline. The discipline imposed by the market led to greater volatility in financial markets and fewer financial intermediation. Of course, while this may have led to healthier balance sheets, it also meant less growth and lower living standards.
The rating agencies and other financial market players provide a type of third-party supervision. They apply a loose system of checks and balances to counteract excessive risk accumulation. The Commodity Futures Trading Commission (CFTC) sets position limits for securities firms, the US Securities and Exchange Commission (SEC) fights securities fraud, and the US Federal Reserve regulates the banking system. These are all worthwhile features. The query is: Does the increased functionality that these efforts bring to financial markets include hidden costs?
This is the principal-agent problem in its purest form. Financial innovations increase intermediation, making capital cheaper and more available. This results in economic growth and better living standards. Lower barriers to entry and seemingly reduced complexity encourage people to speculate their savings within the markets. But beneath the surface, the underlying complexity of the market has never disappeared; it has just been moved to a different location.
If the complexity of our economic system is constant, where is it hiding and who’s managing it?
The dependency paradox suggests that when school leaders delegate responsibilities to others, they could inadvertently reduce their very own ability to make informed decisions, understand complex issues, and retain the talents crucial to perform those tasks well.
Innovations corresponding to Exchange Traded Funds (ETFs) have opened up financial markets in a value and tax efficient manner. Investors can now purchase a well-diversified portfolio with the clicking of a mouse. But within the not-so-distant past such an endeavor might need required teams of execs, and today the mechanism that converts that mouse click right into a portfolio stays a mystery to most. The complex algorithms, order routing, payment for order flow, and execution that happen behind the scenes go largely unnoticed until we read in regards to the outsized profits that certain firms make by providing liquidity to the market.
In a way, financial innovations create two classes of investors: those that simply devour the products and people who understand how the system that produces those products works. This goes to the center of the principal-agent problem. Gaps in knowledge between clients and agents can result in conflicts of interest, but don’t necessarily make them crucial.
For credit standing agencies, the conflict arises from the chance they may pose to the economic system. On the one hand, in the event that they deviate from their disciplined analytical approach, their value as market arbiters diminishes, but in the event that they keep on with it too strictly, a collapse could occur.
To close the inevitable knowledge gap of markets, we must accept that complexity can only be transformed and that agents have to be empowered to administer this complexity to extend the functionality of markets. It just isn’t enough for these agents to be transparent and accountable. It is as much as us, the clients, to observe the financial markets, take part in them and inform ourselves about how they work.
While investing has change into “easier,” behind the easy mouse clicks and user-friendly interfaces lies a fancy world that we must not lose sight of or ignore. This complexity will inevitably reveal itself, and when it does, we must always try to know it for what it’s moderately than panic or blame.
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Photo credit: ©Getty Images / chrisroll
