My first instinct, upon hearing of these difficulties placing derivatives with clients, was to think like Hitler. Clearly, what was needed was an extensive training/re-education program, complete with not just with expert salespeople, but large-scale propagandists, and cultural missionaries as well.
But I quickly realized any such scheme had some fundamental problems. It's just not feasible to teach everyone with some interest-rate exposure what an interest-rate swap is, and how to price it. And it's unfeasible to create around them the environment - to pipe in the information - that would enable them to make the decisions anyway.
The challenge is, in fact, to do just the opposite, to expose participants to the simplest information, and burden them with the simplest decision possible, while still exposing them to the coincidentally opposite interest-rate risk of another entity, in another industry, in a completely different part of the world.
In other words, let's say a homebuilder who is a borrower, is exposed to his bank on the one the hand through a revolving line of credit, and to the homebuyer on the other hand. His bank, in turn, is exposed to a variable rate of borrowing costs, and so passes this through to the builder in the form of a variable rate.
The homebuyers, however, have local jobs and homes. Meaning, even if local conditions rise and fall relative to national conditions, they are still a straight line in their own local frame of reference. Put simply, the price of local homes can afford to rise and fall with the level of local employment and local wages rates, and the local people, rising and falling on the same tide, won't even notice a difference.
So the solution is not to make the builder adjacent to yet a third enity, some kind of borrower with opposite needs in Bangladesh. By the laws of OFT, the more independently-fluctuating regions you make the single builder adjacent to, the larger burden you put on him to improvise a set of dance steps, and the more likely he is to fail.
The solution, therefore, must be to expose the builder to a single, stable interest-rate stream, and move the variable-rate resolution and remote-link complexity one hop away from him - and one hop further removed from the local buyer - by relocating it to the bank. In other words, the local lending bank should enter into the swap, and just give a fixed rate to the borrower.
But if we carry this logic further and further, we will ultimately be left with only local loops. All remote connections between people will be pushed further and further away, until the people connected are closer and closer. Ultimately, you will be left with only local loops, and still these huge differences between them - created by geographic friction - which differences could theoretically be dissipated or exploited to create great wealth.
So, on the one hand, we have distant high and low points, pushing regions to overcome geographic friction, by connecting. And, on the other hand, we have the survival necessities of local structure being naturally averse to these large-scale or macro short circuits which would fry them. Everybody wants to benefit from the remote link, but nobody wants to be next to it himself, in proportion to how distant, and therefore how dangerous, the other end is.
Everybody is naturally scared to death of what's going to come out of that pipe, so he would prefer to be next to it transversely, through his neighbor as a buffer or cushion, and that creates geographic friction. And the cost of being next to it goes down the closer you were going to be to remote the source along other (slightly-longer) paths anyway. Which brings us to OFT and three-dimensional space.
As long as I can remember, I have been skeptical of "three-dimensional space," I was convinced it must be some kind of illusion. But if there are no "dimensions," then why do the laws of trigonometry work on all intermediate scales, between the sub-atomic and the general-relativistic?
Another way of asking this question, is why are points in space a single distance from each other? If you find two equally-circuitous routes between two objects - and how circuitous they are is measured by mapping them onto an exactly three-dimensional continuum, they wil be the same length. Why? Let's use a two-dimensional matrix to draw what I mean. - Z -
A - B - C - D - E
| | | | |
F - G - H - I - J
| | | | |
K - L - M - N - O
| | | | |
P - Q - R - S - T
| | | | |
U - V - W - X - Y
Each letter has exactly four connections. More significantly, of the eight letters each letter is closest to, its neighbor will share five of them in common. Meaning, any shock which comes through the system, is likely to hit them both equally, from externally, at the same time, rather than being transferred from one to the other. In other words, as a team, they propagate and diffract shocks in a "safe" way.
Now suppose we add a fifth connection to M, linking it directly with the remote Z, which is in the middle of its own matrix somwhere else. Any shock between the two will throw each completely out of synch with his neighbors! From Z's point of view, he is helping M, M is out of step in Z's frame of reference. But in M's frame of reference, it is Z who is exposed to the uncomfortable shocks.
The reason I called it "Orderly Feedback Theory" is because suppose each of these letters is oscillating, or sending out a signal to his immediate neighbors. And each letter must learn to buck and roll with his neighbor to absorb the shocks. So each letter's internal oscillation must be a harmonic additive sum of all the external properties of each of his neighbors, and this must be true of every letter in the matrix.
So, by feedback, consider that the signal any letter send out gets back to him. If M sends out a ping to his four neighbors, he will get 1/4 of his ping directly back in exactly two cycles. in 4 cycles, he will get another, smaller fraction of his ping back, along M-N-I-H-M, and similar paths. So notice, the complexity of the single M has to deal with is equal to the complexity of the space around him.
Notice that if we either expanded this matrix into three dimensions, or connected letters to each other at random from near and far, M would have to be the world's greatest musician and poker player just to recognize the echo of his own signal coming back to him. Put differently, the internal entropy or complexity of M must be equal to the complexity of surrounding space, and all its contents - the first law of OFT
So what will happen, if we attempt to connect letters into more complex, n-dimensional configurations - or to link in a "wormhole" from Z - is that M will get overwhelmed and fall out of synch. M and Z will get destroyed, together with the space that connects them, and their entropy will get absorbed by G,H,I,L,N,Q,R, and S - in the case of N - and will radiate outwards in the form of energy.
But this direct connection between G,H,I,L,N,Q,R, and S will also be uncomfortable so, presumably, a new intermediate particle, a new M, will form out of stray entropy. Or something like that...
The real question I was trying to answer, when I came up with OFT, was, if wormholes are possible, then why didn't they form spontaneously in nature? Why didn't wormholes, together with structures that support them, evolve at random in a symbiotic way? Why aren't there large, complex, wormhole-dependent creatures, perpetuating in space?
The fact there there weren't, seemed to prove that I couldn't insert a wormhole connecting New York and London. Because if I did, something bad would happen, it would be unstable, and self-destruct. So the solution I came up with was, in order to operate a wormhole for the purposes of trans-Atlantic shipping, I would have to design an extensive sheilding mechanism at both ends, and only pass electrically inert objects through it.
In other words, the only way a wormhole can survive is if the space doesn't know it's a wormhole. ("Beggin' Strips" brand dog snacks - dogs don't know it's not bacon!) Put differently, so long as you don't let M send out his ping - or as long as 4 cycles later you send him a ping back from both N and H - M will never have any way of knowing that M and H are 10 million miles apart, you can fool him.
So, immediately when Paul and Javelin explained the customer has this natural defense mechanism against derivatives, I realized it was an OFT problem in the cultural/economic scale. Meaning, you can't just slap a new pipe directly between Paris and Milan, and expect everything to be hunky dory. People will get burned by it, and they'll learn not to like it, the way a dog learns not to eat a rock.
So the solution has at least three parts.
1) Realize that a shock may not be a shock in a remote party's frame of reference, he may be naturally hedged against local variations,
2) Once you have synched up with his local frame of reference - rather than some international benchmark - you have to shield him with your very life against any whiff of the outside world, and
3) Use Gestures, to help price in and reduce shocks, and simplify decisions along the time axis.
Meaning, if LIBOR and risk spreads both rise, and you shield a homebuilder against that - but this rise is a reflection of conditions which also affect prospective homebuyers - you could create an oversupply of housing! The solution is not for the homebuilder to build the same number of homes and sell them at the same price, or even to build the same number and sell them at a higher price. The solution is for him to build a smaller number of homes, and sell them at a higher price!
This assumption that his borrowing costs will rise, but his buyers will still have the same jobs, and the same amount of short-term liquidity to "invest" in long-term structures, is ludicrous! Meaning, if the economy gets poorer, the swap participant must get poorer, there is no way around this. Any apparent way to shield him from this using derivatives is an illusion, and the triple-A-rated clearinghouse will go broke in a catastrophic failure to locate counterparties against whom they can dynamically replicate.
This is really just the geographic friction problem. The only way "international" diversification can work is if foreign markets are not correlated. The only way foreign markets can be non-correlated is if there is friction to auditing the foreign valuation information, and moving capital between them. And if there is this friction cost, it should precisely balance any benefits of diversification.
Unless, of course, you have asymmetric friction, which is what wormholes are designed to exploit. But let's move on...
Okay, Javelin pointed how to cope with their new adjacency to this monster, the client had to insert a new team of lawyers, and build and staff a whole new trading desk, just to intermediate the adjacency. In other words, they have to lay some complex, new space in there to diffuse it, and to learn to dance with it, to adjust to it. The trading desk oscillates independently, between the original entity, and the intermediate derivatives intermediary.
The reason gestures help simplify this, is because they prevent the price itself from oscillating, and creating yet another signal for counterparties to have to learn to disaggregate and dance with. Trend traders normally chop markets up and down in a constant oscillation, because they can't tell what signals to extrapolate as coming from end users, and what signals to assume are just coming from other trend traders - meaning they are soon to be reversed along the time axis.
Gestures smooth prices and, therefore, the time-variation of the signal a party is exposed to. So, if we break derivatives down into their simplest strips, and introduce time-axis visibility by overlaying a gestures marketplace, geographically-remote entities will evolve ways to deal directly with one another, in anonymous, many-to-many derivatives exchanges, without getting burned.
So, in conclusion, people's aversions to derivatives are a natural - and perfectly logical - adaptive evolutionary response. And the way to beat these responses, and the problems which trigger them - so that these enormous quantities of unrealized positive-sum matchoffs can be discovered and exploited - is not by earning credibility, or by relocating the locus of decision making, and the necessary information - and therefore the problem - to the next region in space.
The solution is to create simpler, lower-bandwidth, and more easily negotiable adjacencies. The solution is to create commoditized, low-overhead, low-manpower ways for counterparties to meet. The solution is to build some of these new paradigm of electronic marketplaces that I am always designing in my head
You have to pass through a minimum-complexity snapshot of space, which is what a gesture packages. Gestures are just highly-compact and divisible information particles.
In summary, the solution is to take those lines in the letter matrix - "-" and "|" - and give them the properties I tell you to give them! That way, you don't demand either A) that the letters at the points be that complex and sophisticated, or B) that the economic space or topology they are suspended in survive in overly complex configurations. You gotta, like...
I guess you have to be able to picture it! With a pricing mechanism for gesture particles, the quantity of gestures manufactured, radiated, and absorbed - and the configuration of economic space itself - become self-regulating.
It's gotta be natural, people have to be able to negotiate their own, remote relationshios, in super-simple, super-safe, bite-sized pieces, that are easy to get their brains around
You have to take these huge, complex, monolithic deals - and the people needed to structure and maintain them - out of it. It just has to be tiny little windows, with tiny little exhanges, between just two people, that don't perpetuate into their own sine waves, their own, independent entities.
That's the thing to remember, when the relationship between two adjacent things is really complex, a new knot of space forms between them to take up the slack. So the central meeting place, the switching yard, has to have simple, honest prices that don't oscillate. People have to be able to walk up, tap in at price X, and then tap out again at price X safely.
You have to walk into the dance hall, meet someone, and leave, without needing a chaperone, or a matchmaker, or a divorce lawyer, it has to be safe, simple, reliable connections. In reality, gestures are just a way of finding out rigth now, for real, what will be coming out of the other end of that pipe - which immediate prices don't tell you anymore. Gestures create environmental autocorrelation, which fosters advanced evolution.
Okay, I give up, I'll try again another time...
Anyway, here are some supplementary posts:
You know what, forget the supplementary posts...
eLROY