One of the more taken-for-granted things about financial markets (and as I’m studying fine art, those as well) is the role of public prices in the mobilization of prices more broadly. This has sweeping importance, but I’m not sure a commensurate amount of theoretical attention.
I had a chance to chat with a friend who works in valuation for a hedge fund, and he made an interesting point about art prices and how it compares to securities. He, reasonably, considers anything generating less return than Treasuries as being a net negative cashflow investment. So while a stock is a claim on a company’s future earnings, art requires that its intrinsic value rise for it to be a net positive return asset. Unless you can charge for people to see your art (which you, socially speaking, can not), the insurance and opportunity cost ensures that your investment is negative with respect to Treasuries. This is Nassim Taleb’s contrast of Nero and John in Fooled by Randomness, the bond trader who depends on the certainty of earnings, and the stock trader who depends on the fickle beast of global securities markets.
This is all basic. But it really underscores the assumption underlying all financial markets: that prices can be measured against US Treasury Bills as a baseline. Because US shouldn’t default, this is the effective cost of money. And it is the public nature of that rate of return – that Treasuries are sold at auction, that these results are public – that matters so much to financial market actors.
This leads to two thoughts: 1) without the public prices of Treasuries (or some equivalent), there would be no organized, global financial markets; and 2) organizations engaged in private pricing, of illiquid assets and esoteric derivatives, are parasitic on public prices. There’s something important here, though I’m having a bit of a time putting my finger exactly on how to put it.
In an interview with an Asian art specialist, she noted:
Private sales we do occasionally, but we really want to sell through the auction process…Because, very often today it is difficult to establish the correct price for something. What does that mean, the correct price? What is someone willing to pay for something. You have precedents, but if you are dealing with highly unique works of art, certainly in Asian art that is often the case, but also as we’ve seen in the Impressionist sale a couple of days ago, who would know that someone is willing to pay $80 million for a Klimt? That we don’t know. So, the problem with a private sale is what price should you put on this and what price should you ask for it and who do you ask first of the clients you might have for this piece. So, it’s very difficult.
Sure, Hayak, yep, adverse information gets more easily incorporated into market prices than centralized planning agencies, but it’s also that aggressively private pricing makes it harder for everyone to know not just how much, but also how, to value things.
In the late 19th century, this ‘contribution to public price mechanism’ was the basis for claims against bucket shops, who were said to be gambling precisely because they never really contributed to the important work of pricing commodities. Instead, they were more like wagers on the levels at the CBOT.
I like the discussion you’re starting to develop here, but I think that you may over-stretch the conclusions a bit. First, financial markets are not based on using the T-bills rate of return. In contrast, pricing according to CAPM, one of the building blocks of modern financial economics, is based on using T-bills as the ‘risk-free rate of return’. So, a baseline is crucial for pricing according to the efficient market hypothesis, but since not all market participants advocate EMH (I would suspect that many even reject it whole-heartedly), we cannot claim that markets would not exist without a baseline. Second, the distinction between private and public prices is not very clear. Many prices are public and free at certain resolutions (daily, usually) and restricted, or highly expensive at higher resolutions. Having said that, I think that the notion of parasitic relationships that surround prices has some mileage and you may want to take a look at Vincent Lépinay’s paper: ” Parasitic formulae: the case of capital guarantee products” where he develops an analysis based on the concept of parasite (following Michel Serres). Finally, it is true that the bucket shops were piggybacking CBOT prices the CBOT did not claim that the bucket shops’ operation was gambling because they used CBOT prices, but because they did not exchange goods for money. I have a working paper about this. (http://www.lse.ac.uk/collections/CARR/pdf/Disspaper44.pdf)
I should address the last first, since it’s a more empirical question, and your former set of questions is both harder and more important.
CBOT’s claim that bucket shops were gambling because they didn’t engage in delivery is about as true as the claim that the US invaded Iraq to find WMD. It was a politically-useful claim, which gained traction in US courts, but I think the underlying criticism stemmed from CBOT’s desire to capture all the trading traffic, and to convince a restive populism that trading wasn’t gambling. As far as I’m concerned, intent to deliver was always a scam.
Interestingly, when I was doing research on this at the Chicago historical society, I found old correspondence between CBOT and one of its lawyers, saying that there was no real law they could write to outlaw bucket shops that wouldn’t also outlaw futures trading – perhaps not decisive, but evidence that the ‘no delivery’ claim was hit upon rather than a theoretically coherent reason. My reading of the historical record suggests CBOT traders themselves hedged their positions in bucket shops – and someplace I remember the Board decided to soap up the windows so traders couldn’t flash prices to bucket shops downstairs. So I would say that ‘contribution to price discovery’ was also one of the reasons CBOT tried, but it was not the one that could was convincing to courts.
As far as the first part of your comment, this is the heart of it. I would claim that there can be (and is, and has been) exchange without public prices, but can there really be a market? There are two elements here. First, the knowledge required to make decisions about how to price things (price ontology). How can you know if a 10% return on investment is good, bad, etc., without some answer to the question, “compared to what?” The ‘riskless rate of return’ – or for many individual people, the interest rate you can get in a savings account or something – is the answer to that question.
Second, in the high modern sense of high finance, naked positions have become relatively rare with the great exception of scalpers. So, yes, CAPM users are most likely to be both practically and theoretically tied to treasuries as a riskless instrument. But wouldn’t you say that other traders are also tied to treasuries, whether this be implicitly or explicitly?
My argument is something along the lines of Abolafia’s discussion of bond traders in the 1980s, with there being two prices – in the street and bank-to-bank. The private (bank-to-bank) market was attached to the public (in the street) prices, sometimes directly and sometimes not, but always somehow…
In the main, though, you are right that the claims don’t match the argument quite yet – it’s more of a flag-in-the-sand statement so far, which I have a notion about but am not ready to tie it together tightly enough yet.
Interesting answer and a nice discussion.
Looking forward to pt. II
Yuval