The absolute backbone of finance is simple math. The vast majority of financiers will not use more than basic algebra in their work, and yet every aspect of finance, from payments settlements to derivatives to market access and beyond, is very, very complicated. Why is that, and is there a simpler solution?
For much of history the intricacy of the financial sector has been a point of criticism and complaint. Arguments from heterodox corners usually call for some level of simplification—fractional reserve banking is a very complicated industry, so why not make all currency backed by gold? Or bitcoin? Payments settlement involves third parties where trust is centered—can we use smart contracts or blockchains to subvert that? Maybe our entire monetary system, with the multiple levels of money supply and confused interconnectedness could be streamlined.
The finance minimalism behind all of these efforts seeks to strip down complexities in the system as if they are unwanted bloat intentionally put there to obfuscate, confuse, or keep out. In reality, financial markets are the exact opposite.
In general, if you want to make money in a market you want it to be as open and have as many participants as possible—larger markets mean larger opportunities for transactions and, ultimately, profit. The idea of special traders who get secret access to a market the rest of the world doesn’t have access to is kind of silly—smaller markets are smaller opportunities, anyhow—and while these do exist (private equity, for instance), their specialness has been in decline for decades (regulation has made it easier for non-qualified investors to get into these markets). Furthermore, that specialness is almost always dictated by regulations of markets and not the markets themselves.
In reality, markets tend to become more complicated over time as they require, usually as a response to corruption, manipulation, cornering, or other manipulative efforts by an individual or cabal to gain an outsized control of the whole. One way to stop this from happening is to make rules, but other inventions like financial derivatives also exist to cut down on the oversized influence of one participant.
Other complications happen over time to allow more people in. A good example is the U.S. housing market, which has ballooned both in size and complexity over the last couple of generations that few stop to think about how complex this market is or why it is that way. Community banks will lend money in regions around the U.S., and decades ago they would’ve kept that mortgage on their balance sheet, limiting the amount they could lend to others in the community. Markets like the one trading mortgage-backed securities developed specifically for these banks to offload those assets by selling them to larger banks who benefit from the cash flow while smaller banks benefit from the liquidity.
Of course, these innovations provided new problems—as innovations almost always do. In the case of MBSs, the problems it created were absolutely enormous by the end of the 2000s, so that the subprime mortgage crisis created an almost existential crisis to the planet itself. This was not possible without the expansion of the U.S. mortgage market in its complexity and size—but it was also a necessity, because if it hadn’t happened millions of Americans would not have access to home ownership.
This example demonstrates a core principal in financial innovation: new innovations provide opportunities and risks, and if the latter is not correctly identified and accounted for, a disaster can happen. This can occur in two ways. One is that poorly thought out products will explode in the producer’s face, creating significant private losses for a small group. Another is that the products are poorly regulated, creating significant risks to the market as a whole.
In reality, both of these disasters rarely occur, which is what makes them noteworthy. The invention of other financial innovations, like stock options and bonds and interest rate swaps, did not create huge blowups like the MBS disaster of 2007-2009, in large part because these products develop over time to fulfill needs and are smoothed out by market participants who slowly make the market more efficient. But that path towards efficiency often involves more innovations and inventions along the way.
Finance is not hard because it works actively to keep outsiders out—finance is one of the most inclusive sectors in the world, encouraging and demanding more and more people operate within it in order for liquidity, access to capital, and innovation to flourish. But it is hard because it is trying to do very hard things: for one, it is trying to identify and limit risk as much as possible by spreading it around—the ultimate function of the MBS was to limit risk taking by any one party in the system. This is an attempt to quantify the qualitative, so of course it is bound to fail—but by making the system complex to identify and correct risks before they happen, the failure rate we have to tolerate can go down significantly.
Understanding why a market product, structure, or relationship exists often involves digging deep into the history of the market and asking some important questions, like who is being protected, what risk is being identified, what market is being accessed, and what failsafes are in place? When one asks these questions the very complex plumbing of just about any financial system starts to make a lot more sense.