I’m the author. Thank you for saying it is an excellent read — that was no small amount of work.

You ask “Where is the productive output of all these arbitrage shell games?”, which is a very fair question. The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them. E.g., you are not the optimal person to hold the risk that, through no fault of your own, your house burns down. That risk exists, and you are not the optimal holder of it. Hence insurance. A Lincolnshire farmer — and yes, I like the non-abstract solidly of the example — is not the optimal holder of the ‘risk’ that the Australian and Kansas wheat harvests are super-bountiful. Markets allow that risk to be transferred to a non-farmer better able to hold the risk.

Of course, with markets come some ‘unproductive’ stuff. Likewise, democracy is good, but that is not necessarily praising the optimality of all parts of campaign finance legislation.

Let me also mention that I am the author of the definitive reference book on old Vintage Port: Port Vintages (and seemingly the board disallows a link).

Prices and financial markets in general exist solely for information transmission. The central problem of economics is "How do you produce the things that your population needs, in the quantity and at the time they need them, as efficiently as possible?" This is why every centrally-planned economy eventually fails, and why we were stuck in the feudal middle ages for a millennia. Information (and incentives) about what to produce and how to produce it efficiently weren't getting to the population at large, which caught us in a local subsistence minima. Financial markets give all the players an incentive (in the form of profit) to transmit information (in the form of prices) from people who want goods to people who can supply them.

This is also behind the theory of why certain forms of financial transactions are legal and others are illegal. Arbitrage = legal, because it converges prices in two separate markets in a way that gives producers in both those markets better information about true demand. Futures markets = legal, because they smooth out temporal fluctuations in demand so that producers only have to worry about producing, while also incentivizing the construction of just enough storage & buffering to hold that product. Pump & dump schemes = illegal, because they distort price information in the market in an unsustainable way and then leave later participants to bear the cost of this. Same with Ponzi schemes. Equities markets = legal, because they transmit information about the overall cost of capital within the economy to firms, which can then use it to decide the profitability or unprofitability of various investments.

Farmers use futures contracts to protect against price risks [0]. As do energy suppliers [1].

[0] https://www.ers.usda.gov/webdocs/publications/99518/eib-219....

[1] https://emp.lbl.gov/publications/primer-electricity-futures-...

Whilst arbitrage is certainly something which exists in the financial markets, the vast majority of what's done isn't arbitrage. Arbitrage assumes differing views on valuation of an asset today. So I can buy something from person A, which they believe to be worth value x, and sell it to person B, who believes it to be worth y, where y > x. That's arbitrage in its simplest form - the market has priced something incorrectly, and I can buy it from willing sellers, and sell it to willing buyers at different values at the same time.

The vast majority of financial transactions aren't this - they're speculative. They bank on the idea that money now is worth more than money in the future, and the future value of an asset (using the definition of an asset that it's a sequence of cashflows) is both variable and uncertain. So therefore the promise of future money is inherently tied to the concept of risk. The majority of financial markets trading is based around this concept of risk, and the management of it.

There's vastly more complexity under the hood, but that's roughly speaking, accurate.

> Where is the productive output of all these arbitrage shell games? How is this more than an abysmal waste of time and resources simply to make a small handful of bankers richer?

If shares of companies are valued at fair prices it means that the finance departments for that companies can raise more capital. So companies that bring value to society should be able to expand their business.

At the same time, regular people can invest in such companies at somewhat fair prices without doing much analysis. Basically, because the profits above the market average have been taken by smarter investors already. But it’s still good to always be able to put money somewhere and receive avg. market returns.

Without them we wouldn’t have McNuggets.

McDonald’s is known to have almost invented and streamlined cooking to industrial level. But McNuggets were made possible only through financial engineering:

https://tackletrading.com/tackle-today-the-rise-of-chicken-m...

I just finished some McNuggets so it’s even more funny to me right now.

Arbitrage and it's various squishier more stochastic cousins are the vehicle by which information flows through markets. Markets exist as a global network of interactions and persistent imbalances anywhere in the system can have massive consequences. Generally, these consequences rhyme with "two counterparties which don't interact with one another directly all that often suddenly discover grave disagreements in the desired price and quantity of something they'd like to trade". Economic wreckage is the result, at least, but also imagine what would happen if corn farmers produced only half the crop that their buyers would have liked to purchase.

So, markets work pretty hard to make sure that information from one area of the global economy can flow to all of the rest of the system with relative efficiency. This works a lot like a game of telephone where changes in one market venue propagate through related instruments to other venues crossing space, species, and even time. Much like telephone, each pair of neighbors wants to do a good job sharing information without loss and, also, over long distances minor errors add up.

Arbitrage is the glue which prevents this from happening. Arbitrage says that any time anyone discovers some level of disconnection occurring, they can make money at very low risk by voting to shift markets to better align with one another.

Arbitrageurs are getting paid to provide a service to the market and subsequently the entire world. Their actions ensure that information flows throughout the global financial system quickly and without relying on centralized planning. Without them, markets could become disconnected and wander out of agreement.

The arbitrage game keeps the prices consistent with each other. It serves to create liquidity so that participants can get their business done without either waiting too long or paying too much.

The thing that I’ve always found wild is that the money people make on markets seems to be so much higher than the money people who actually make goods/services.

Why has the global economy put such a high benefit from investment bankers compared to, for example, family doctors?

Risk management is the product. Surely you agree that a product that reduces risk is worth something, right?

The output (generally speaking, not specific to money markets) is better prices. There are large scale examples of economies in which prices were mismanaged either due to lack of information/technology or centrally planned prices, some of which resulted in failed states (e.g. Venezuela and the Soviet Union). While providing market information signals via prices is certainly an abstract concept that most people will never appreciate, it is important regardless.

For complex instruments in money markets, the main effects are bridging mis-priced treasuries on different time frames and hedging against various outcomes for pensions, banks, and dealers in physical commodities.

Most of the complex stuff either serves one of those purposes or becomes a zero sum game that doesn't affect non-participants. It's important to judge each instrument by its purpose and mechanism rather than bunch everything as a way to make bankers richer (e.g. a future vs. a CDO).

Futures and options were born from commercial needs.

Suppose you produce oranges. It'll take a few months for the harvest, and while costs are generally well understood and stable, at what price will you sell those oranges? What if by then the price of oranges tanks and you find out you're not turning a profit? This is where futures come in. The producer can sell a number of futures contract to lock in a future selling price, making cash flows much clearer and predictable.

Conversely, there's the case of a factory that needs to buy oranges for its products. They have the opposite problem and would like to make costs more predictable. Then they'd buy futures to lock in a future buying price.

> How is this more than an abysmal waste of time and resources simply to make a small handful of bankers richer?

Interesting observation given that your own wealth is managed this way.

Whether its the simple bank deposit in a checking account, if you've ever chased an interest rate for a savings account, or had your earnings managed in a retirement account from your employer, or if you attempted to make money faster because a debt was coming due.

Its all tied together and a product of this system.

The goal is to keep money moving within the economy, as people also race to hoard it.

Generally speaking you can group large financial institutions into two groups: sell side and buy side. I’m no expert, but afaik, these firms either SELL liquidity (e.g. investment banks, market makers etc.) or BUY liquidity (for example pension funds, certain hedge funds). Liquidity is the key here - that is (if any) the benefit they bring to society. I can buy/sell pretty much any financial product/risk with reasonable spreads because there’s always someone on the other side of the trade ready to be my counterparty.

Not that I want to defend some of these institutions, though some are better than others, but it’s important to keep in mind that they do take on risk in order to provide us liquidity, and most of them specialize in managing the risk, some of them are even good at it. Their infrastructure and connectivity and the price they charge you to provide liquidity allows them to make profits, but they do lose money sometimes. Also, compared to 20 years ago, there’s fierce competition now in pretty much every aaset class - if you work in one of the buy/sell side firms, you’ll very often hear terms such as spread compression etc (except the Covid years of course - people just wanted to trade, nobody cared about the price of liquidity (e.g. spreads or sales credit etc.) they had to pay)

Not sure if you meant “money market” as it’s understood to be the market lending/borrowing for terms of less than a year, or if you were referring to fixed income markets in general.

Either way it’s hardly a waste of time or money, and banks make money not from “arbitrage shell games” but by matching buyers with sellers. Some people have money to lend and sone people have enterprises they need to fund.

While there are casinos, think: A farmer wants to get a fixed price for next years crop and insure against a bad harvest. Thats why you need these things.

Ok the farmer example is a trope apparently. Any business where you need to hedge financial risk. Lending too many mortgages to self employed people? Sell that risk / revenue stream on to someone else and buy something different to diversify.

Others have provided excellent answers. There's one thing I'd like to add. In order for the financial markets to provide more utility, a financial transaction tax needs to be introduced. It will indirectly kill unproductive or counterproductive financial activity such as high frequency trading.

These days - figure that it is 1% "honest & productive uses", and 99% society-undermining casino.

Sibling comments have provided good explanations of why modern economies need finance: risk management, capital allocation, enabling ventures, and so forth.

At the same time, it’s worth asking the question of why the financial sector just keeps growing and whether that’s desirable. Shouldn’t improved efficiency with digital systems make this intermediation layer thinner, less labor-intensive, more competitive? Instead it seems to be capturing an ever larger share of the economy’s output to itself.

In my opinion regulators should try deploying some blunt tools like transaction taxes and hard salary caps, and see if we’d be any worse off with a smaller and poorer financial sector.

One example which is applicable to majority of the working population: in the UK at least the fixed-rate mortgages are priced off the Swap rates as that is how banks hedge them.

The value add is offering financial products that consumers want.

Businesses and people need to loan or borrow money, offering a wide variety of products that suit different needs supports economic growth.

A good example of this are all the foreign companies that decide to go public on the NASDAQ. They aren't doing it in their home country because of a weak (or non-existant) equities market, or burdensome regulation.

Sounds like you worry too much about what other people do with their own time and money.

I'm with you, but I apply the same logic to all rent-seekers and shareholders. We'd be a lot better off if we didn't have parasites and bottomless pits embedded in the economy by design.

Same with the majority of tech companies. All you do is endless meetings, plannings, reviews and extremely little actual human brain is used for productive output.

Meaningful prices for the rest of us

Great questions, but no reply will be coming at you.

Except an apologetic nonsense-logic-it-is-obvious-it-works trope.

Only product is the profit.