Monday, February 25, 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (2)

i) A nomadic capital with the need for rapid deployment under varying circumstances needs a new organizational shell to operate; the old mutual fund structure, where the type of activities must be specified in advance, would not do. Hence, the rise of hedge funds, where prospectus and offering memorandum give virtually unlimited discretion to the managers to engage speculative capital in spontaneous opportunities anywhere they arise.

Hedge funds are the organizational/legal form that speculative capital assumes in the market.

ii) Flexibility of its own structure is not sufficient for rapid execution; speculative capital needs accommodating market conditions as well. To that end, it adopts the derivative structure – long the narrowly used tool of farmers and commodity producers – to its own temp. Derivatives are the ideal vehicles for “linking” one market with the other.

Derivatives are the functional form that speculative capital assumes in the markets.

iii) Speculative capital does not have a command and control center. Whenever an arbitrage opportunity is detected, the mass of speculative capital, employed by thousands of hedge funds and proprietary desks, is directed to it. The rush of uncoordinated money overshoots the mathematical exactness of the relation, with the result that that the pendulum swings in the other direction.

Volatility is the result of attempts of speculative capital to profit from arbitrage.

iv) The “inefficiencies” that speculative capital exploits are small. (Consistently large spreads would imply a crude and inefficient economy that would exclude the rise of speculative capital.) The narrow spreads cannot sustain speculative capital. To boost its return, speculative capital needs to leverage itself. The smaller the spread, the larger the leverage.

Speculative capital has a tendency to employ increasingly greater leverage.

v) Speculative capital eliminates opportunities that give rise to it. This necessarily follows from its modus operandi. Simultaneous buying low and selling high increases the lower price and decreases the higher price, gradually narrowing the spread between the two and ultimately brining them into “equilibrium” and eliminating the arbitrage opportunity.

Speculative capital is self-destructive.

Self destructiveness is a logical tendency that manifests itself over the long run and in the context of the particular markets speculative capital is arbitraging. At the same time, speculative capital is antithetical and will not gently go into that good night. As the spreads erode, speculative capital will:

a) Compensate for the falling returns by increasing its size and leverage, thereby exacerbating the erosion of the spreads.

b) Search for new markets and products to arbitrage. In this way, speculative capital “links” the markets – first various markets within a country and then markets across the globe – by targeting products in them as the subject of arbitrage.

In consequence, ever newer markets are drawn to the orbit of speculative capital. The sole “use” of these emerging markets is their offering of arbitrage opportunities, hence their name: emerging markets

vi) The sovereigns have laws that might stand in the way of expansion of speculative capital. Those laws must give way to the exigencies of speculative capital. Ditto the local laws.

Speculative capital drives the march of deregulation, particularly in the financial industry.

vii) The linked markets – whether various markets such as commodities and equities within a country or different markets in different countries such as currencies – become the subject of the arbitrage action of speculative capital, with the result that their movement is synchronized.

Speculative capital increases the correlation between the markets it exploits – national and international.

To any one following the markets in the past 30 years, these are familiar developments. The explosion in number of hedge funds, the exponential growth in derivatives, the incessant drive for deregulation, synchronization of price movements across the markets, rise of emerging markets, increasing emphasis on shorter horizon – these are instances of different manifestation of speculative capital.

The current crisis is byproduct of speculative capital’s arbitraging of credit. The “credit” in question is the potential loss of the credit or loanable capital arising from the borrower’s default.


Thomas GER said...

There is some tension between III) and V). Tendency III overshoots, destroys equilibria (creating new arbitrage opportunities?), whereas V tends towards equilibria destroying arbitrage opportunities.

Nasser Saber said...


Yes, there is, as there should be in a dialectical process. The tension you are referring is the core of the dialectical method, the identity of opposites, which, Stace, in his Philosophy of Hegel calls "one of the most striking pieces of speculative audacity in the history of thought." Then he adds: "But this audacity is justified and was necessary if philosophy was ever to solve its ancient problems".

I will have a lot to say on this topic in Vol. 4. For now, let me again quote from Stace. Let me know if it helps:

"We begin with category being. It is the pure category that we have to think, not any particular sort of being, such as this pen, that book, this table. It is the entirely abstract idea of being, being in general, pure being. We have abstracted from all specific determination whatever ... It is therefore absolutely indeterminate and featureless, completely empty and vacant, a pure vacuum... This utter emptiness is not anything; it is the absence of everything. But such absence of everything is simply nothing. Emptiness, vacancy, is the same as nothing. Being, therefore, is the same as nothing. And the pure concept of being is thus seen to contain the ideal of nothing. But to show that one category contains another is to deduce that other from it. Hence, we have deduced the category of nothing from the category of being.
Since they are identical the one passes into the other. Being passes into nothing.And conversely, nothing passes back into being. In consequence of this disappearance of each category into the other we have a third though involve here, namely the idea of passage of being and nothing into each other. This is the category of becoming.

Thomas GER said...

Interesting (of course up to now still general or abstract explanation).