Prices and Promises
We can do more and we can do better. We have done much and we have come far but is it fair or efficient or robust ? Please join us on a flight of fancy. We want to reimagine core elements of human activity through the lens of practical technology.
Humanity is transactional. We exchange value, or more correctly what we perceive to be value. Cooperation, commerce and society writ large are essentially a basket of transactions. Some transactions are priced some are not, although these are probably based on a mutual value perception. Some prices are explicit, some are not. Some transactions reference a common medium of exchange; some don’t and are effectively barter. Some transactions are immediate, some are not. Those that are not imply a future commitment, a promise. Not everyone delivers on their promises. All transaction have consequences. Some consequences are immaterial others are not. Some consequences are short lived, some are not.
In this piece we want to put a price on everything. Let us be explicit. We want to evaluate promises. Let us understand risk and uncertainty and consequences. This thought experiment maps cleanly onto the broad platform that is financial services — we discuss banking and insurance briefly but wish to highlight that the application is not bounded by these. The technology to deliver what we want is on the horizon. Let us show you how ….
Prices
Why do we assign a price ? We ascribe different values to different things at varying times as our perceptions change. We discriminate — continuously and in everything, consciously and subconsciously. In our transactional frame there is always a value exchange. There is a cost and there is a benefit. This treatise is primarily focussed on the efficient and transparent determination of the cost, however, it is important to note that all actions have consequences and that these consequences are effectively costs. No system of price determination (or for that matter promise management) can survive an environment where bad choices are not punished. Mistakes can be socialised, but not sneakily after the fact. We argue that transactions must primarily take place between adult actors who can assess costs and benefits and deal with the consequences of adverse outcomes.
We start with simple prices for de facto commodities. Many activities are transparently priced and executed with reference to a medium of exchange. We buy food. We rent property. We work for a salary. How do we set these prices? Value perception varies across participants. Asymmetric information generally favours those with more data, most acutely in the short term. If I know you will pay 10 units for apples which I can buy around the corner for 5 units, I will charge you 10 units for as long as you don’t know what it costs me to source the apples. In addition I may sell the apples at 6 units to someone else who happens to know what I pay for them, but I will continue to charge you 10 units as long as you don’t know. Perhaps some may feel that caveat emptor applies — buyer beware — but this is inefficient. There is a reward for obfuscation, not for effort, risk or innovation. Transparency and disintermediation, both on a radical scale, will significantly reduce the rewards to asymmetric information and improve overall system efficiency.
Some activities are harder to price. Promises, explicit and implicit, are embedded in products and services. Explicit promises are relatively easy to see. For example, I borrow money and promise to pay it back. I incur a charge (by way of interest, margin, fee or premium), effectively a price, that should reflect how likely I am to honour my undertaking. The more unreliable my repayment is, the higher the price.
Implicit promises can be a little tougher. To illustrate, consider the earlier example. What if the apples for sale are produced on a shared patch of land ? What if that land is overworked this season, rendering it less productive next season ? Was there any undertaking on the part of the seller ? Should there be ? Who is responsible for this consequential cost ? What if it is an unintended outcome ? The tragedy of the commons is by no means a new effect, however in pursuit of radically transparent pricing we should expose all costs and avoid sweeping unpleasant outcomes under the shared risk rug ! We argue aggressively that individual risk implies individual responsibility BUT we must consider group risk.
Our proposal is akin to an expanded financialisation of commerce and human activity. This activity has to date delivered benefits to those restructuring the interaction as well as those making use of the instruments. A fair criticism may well be that the former has benefitted at the expense of the latter. We argue for a better mousetrap, where atomic components are defined that can accumulate into more complex packages or interactions. The consumer knows what they are transacting, and there is no hidden financial wizardry at play !
Promises beckon, but before we move on let us leave you with a circular nugget to ponder. Pricing is effectively a means of information dissemination, yet information is a key input to pricing. Surely our data (financial and otherwise, personal and pooled) has value and demands a price? Knowing me makes a better product — it is time to pay explicitly to know me ….
Promises
Promises abound! Transactions for immediate settlement, with delivery versus payment and the absence of ANY consequences are rare (if they exist at all). All (other) activity has elements of promises made and therefor promises priced.
The radically transparent pricing mechanism motivated above (atomic level pricing and recognition of consequences) targets efficiency and fair pricing. The challenge of pricing promises is that the quality of promises varies widely. In evaluating a promise one must consider both the outcome embedded in the promise and the likelihood of the promise being honoured. The cheapest sticker price is probably not the best value. We need to think about WHO makes the promise. Some promises can be explicitly priced — the interest rate on your home loan or the premium on your car insurance (although this should highlight the complexity in bi-directional promises — I promise to pay a premium, which is set according to an estimate of the likelihood of a claim, while the underwriter promises to pay if there is an event, both parties take risk) — while others are implicit (or at best confused and obfuscated) — consider friendship OR a nation states’ commitment to provide security. Readers may quibble as to the value of pricing ALL promises explicitly (we concede that personal relationship valuation probably lies beyond the scope of quantification) but we do wish to highlight the impact of broken promises and the failure to price appropriately.
We live in a very connected world. Actions have consequences and these consequences are transmitted through our highly networked commercial, interpersonal and political planes. To illustrate, consider the impact of my failure to make good on a loan that is due. The lender suffers to the extent that they are unable to recover the full value of the outstanding obligation. Sadly though, the pain is transmitted, as my failure may lead to the lenders inability to meet their obligations. The damage can cascade through the system reaching and hurting a set of entities well beyond the original contracting parties. You may argue that the solution is to only engage in promises that will never be broken but that is trite. Human activity would grind to a halt. We are fallible and risk is implicit in all we do. Perhaps we should eliminate or minimise leverage (both a lender and a borrower you cannot be). This too would be disastrous as the velocity of money would decline precipitously, taking activity with it. The solution is to recognise the risk and manage exposure accordingly. The prospect of obligations being met is enhanced by the promise maker keeping a little bit of capital (social, political or financial) in reserve to make good on unexpected events. The more likely and the larger the event, the more capital we need. To the astute reader, this may sound like a veiled tribute to the fractional reserving system of banking, but for all the evils imbued in finance we have yet to see a superior risk management system for a networked environment in the presence of leverage. Collateral, however, is the great equaliser. If we are pricing EVERYTHING then we are able to leverage all elements of a transaction (the process, the flow, explicit risk mitigants etc.) and reduce the need for excess capital. Of course, in praising the modern financial system we are not for one moment suggesting it is fit for purpose or close to efficient. Regulation is a dull tool targeting yesterday’s activity to reduce today’s obvious risk, delivered by a clique for the privileged few by humans that are both blinkered and emotional. Fairness and transparency can do wonders ! Capital, collateral and information facilitate transactions and keep the system honest. Regulation need no longer be conducted by a group of wizened sorcerers in an ivory tower, rather it is a set of unbreakable rules that whilst they do not negate the risk of failure they match the risk understood to the exposure taken. In addition a network of promises lends itself to tools that focus on network resilience. Connectedness and structure suggest an incremental tool for risk management, namely what if the very links between entities can add security by considering the impact of cascading failure? Distant nodes with limited connections may offer better prices. Risk can be managed by hedging your location in the network.
The pot of gold at the end of the rainbow?
This brief note promised (sorry!!) a flight of fancy. Perhaps we have brought you along into a world of prices and promises but what of it? Let’s stick to the world of financial transactions for the time being. Radical transparency and near universal application in pricing can deliver enormous value. Unfair rents to capital or information barons can be attacked. Promise management across the spectrum can deliver superior risk adjusted returns and a fair yield for risks taken. Collateral is everywhere and everything which can facilitate much wider participation (access to information, capital and regulation are no longer obstacles). Networks can be managed and manipulated to reduce risk. This is NOT the world we currently occupy, BUT how far from it are we ?
Technology, from yesterday, today and tomorrow can facilitate our fictional finance fantasy:-
· Transparent, cheap and complete dissemination of information — be it product, price or promise for individuals AND groups
· Transparent, cheap and complete transacting.
· Pricing of things and of activity.
· Systemic management of promises before and during as opposed to after.
· Systemic management of the underlying network that transmits our prices and promises.
We can imagine a world with robust, distributed exchanges (vs. the current club based models with high entry costs and oligopolistic pricing) for ALL products and services (vs. the current suite of traded instruments numbering in the millions BUT orders of magnitude off the mark), with universal access for buyers and sellers (vs. the current gated and obfuscated model), that recognises static, network and flow based risk absorption capacity — near real-time capital and collateral (vs. yesterday’s accounting values) in a regulatory environment blessed with real rules managed by emotionless machines that consider promises before and during the transaction (vs. the dated and fallible environment today).
There will be much more trade, at much better prices, with adult consequences to action tempered by group responsibilities.
