Dealing with complexity requires shifting our focus so as to look at not just the parts to a system but also the overall macro system as a whole. Ideally, this means formulating some kind of overall systemic model of the financial organization we are dealing with. Even if this model may appear very basic it helps to structure our reasoning and place our more focus analytical understanding within a broader conceptual framework.
Finance serves the function of accounting for and exchanging economic value. Financial systems allow funds to be stored and moved between economic actors; they enable individuals and organizations to share and exchange ownership with the associated risks and returns. A key distinction in financial systems can be made between systems designed to enable immediate economic exchange or systems designed to enable the longer-term exchange of ownership through investment; this can be thought of as a distinction between liquid capital and investment capital.
Financial systems enable the exchange of products and services via liquid capital where currencies function as a shared medium of exchange enabling people to fluidly exchange underlying economic resources. Investment capital is concerned with the allocation of assets and liabilities over space and time, with associated risks and returns. To facilitate this recording and exchanging of economic value a financial system converts economic claims to ownership and liabilities into an information based form of a financial asset or liability. As such we can say a financial system is an information form of the real economy; it is an information system for the recording and exchanging of value.
Finance quantifies underlying value within the economy and creates an information representation of that in the form of what we call a financial asset. Financial assets derive their value from a contractual claim on an underlying economic asset. The point of this is that information can be more easily stored, processed and exchanged than real economic assets. This linking, recording and exchanging of economic value creates a network of interlinked assets and liabilities, a financial system.
A system is a set of elements and relations between these elements through which they form an interconnected whole. We can then represent an element(node) in the system as a financial asset or financial entity. A financial asset is a claim to some economic resource – when the value is negative it can be termed a liability. A financial entity is an individual or organization with an accounting record of assets and liabilities represented as a balance sheet. A node in the system can be represented by a single absolute value of the size of their assets. Connections represent the exchange or linkages between assets and liabilities between different organizations.
To serve is function a financial system has to be able to record and move assets from one entity to another; from those who have savings to those who need it for investment; from those who are buying to those who are selling a good or service through a currency; from one generation to another through inheritance; from individuals to public administration through taxes; from low interest nations to locations of high returns through stocks, bonds and loans; for spreading risk through insurance, for joint investment via special purpose vehicles. This relationship between those that have capital(the investors/buyers) and those that need it(debtors/sellers) forms the core of what financial systems are and do. Nodes in the network make decisions about how to allocate their capital so as to obtain the economic resources they desire through exchange or investment. Nodes exchange resources or invest in other nodes to generate a return on their investment or obtain the things they desire. Financial assets are used as the medium of exchange. They serve as a standardized medium of known value for which goods and ownership can be exchanged as an alternative to bartering.
The type of transaction – and type of financial security used to enable it – can be seen to exist on a spectrum of liquidity, which defines how widely accepted and rapidly a financial asset can be converted. Economic exchange is done through liquid capital, such as fiat currencies. Investment is done through capital markets in the form of various capital market instruments, such as bonds, stock, commodities, derivatives. These are all claims to ownership or claims to a portion of a revenue stream. A derivative instrument is a contract that derives its value from one or more underlying entities. Financial intermediaries – such as banks, insurance companies, hedge funds and various forms of market makers etc – perform the function of aggregating resources, spreading investments and enabling exchanges.
Financial entities make exchanges to obtain the things they desire. All exchanges involve a dynamic between risk and returns. Risk defines the potential of a financial loss and returns defines a gain e.g. when we exchange liquid capital for some good it may or may not deliver the functionality we hoped for, when we invest in a company it may or may not deliver returns, these are forms of risk. Through financial instruments like loans, bonds, shares etc. financial entities connect their risks and returns with others within contractual agreements. Participants in the market aim to price assets based on their underlying value, their risk level and their expected rate of return.
Thus the core of a financial system is the relationship between creditor and debtor and the risk-return ratio of that connection, which defines the contractual agreements as to prices, dividends, liabilities etc. Much of economics can be understood in terms of investment, risk and returns; buying a house or bicycle, starting a company, a government choosing to build a new bridge in the hope that it will stimulate the economy. Combining assets makes it possible to spread risk and returns and thus engage in larger investments without any one party needing to take on the full risk or provide the full capital investment cost.
All systems can be defined as either simple linear systems or complex nonlinear systems. The increase in complexity is a function of the number of different component parts in the system and the degree of interconnectivity and interdependence between those elements. A simpler system is one that has few parts with those parts being relatively undifferentiated and independent. A complex system is one that has many diverse components that are highly interconnected and interdependent.
As the cost of the transaction goes down resources can be more easily moved around in the system and assets and liabilities shared. A financial system is a type of information system, thus the form of the financial system is heavily contingent upon the underlying information technology used to enable it. The financial system’s capacity to share assets and liabilities is relative to the level of the underlying information technology’s efficiency at recording, organizing and exchanging financial information. The complexity of the financial system is fully contingent upon the information technology used to operate the network. Coupled with this social factors such as legal frameworks are key to the form of the financial system.
An increase in complexity changes systems in fundamental ways and the same can be said of financial systems. At a low level of complexity with few parts, limited connectivity and interdependence simpler systems can be described as just a set of parts; because the parts are not interdependent they do not form synergies and thus the whole is simply equal to the set of parts. As the system becomes more interconnected and interdependent it starts to take on a networks structure and the conditions for systems level processes and phenomena emerge. Whereas we can analyze simpler systems as being closed this is not the case for complex systems because they are open systems it is required that we understand the system in relation to its environment.
Subjectivity is a key aspect of complexity. Simpler systems due to their finite amount of components and limited interactions can be fully knowable and thus there can be one correct way of knowing the system, one right answer. Complex systems can not be fully known and thus any valuable insight must be recognized to be subjective and a product of a multiplicity of perspectives.
As systems go from simpler to more complex they go from being linear to nonlinear. With low degrees of interconnectivity and interdependence in simpler systems, an effect can create a cause without the cause returning to its source, this is called linear causality. As we increase the interconnectivity there are more channels for an effect to return to its cause and this creates a feedback loop between elements within the system. This feedback creates interdependence, and it means that the system can change very fast as actions become coupled; what one actor does can feedback to induce another to do more of the same action, creating the possibility for compounded exponential change.
As the system becomes more complex, i.e. larger with greater connectivity with more channels for effects to propagate through, it becomes more difficult to trace through the implications and effects of a given event and how it will feedback to its source. Financial systems are dynamic, meaning they change over time. These dynamics can be understood and modeled in terms of feedback loops. The long-term dynamics of a complex system are a function of positive and negative feedback loops. Negative feedback is a balancing loop where the agent is connected to the costs and benefits of their actions. When the cost and benefits to the agents in the system are connected – through a feedback loop – to the whole then the system is stable because there are no externalities.
When the agent’s actions are not connected to the consequences, there is the option for externalities, which can be both positive or negative. A positive externality is when the actions of the agent add value to the whole and thus over time it evolves to a higher level of organization. Positive synergies between both parties involved in the exchange can create value for the overall organization, many examples of trade are positive-sum games. Likewise, investments can be also positive-sum interactions, wealthy nations may have a large amount of capital with low growth, while emerging economies may have high growth potential but lack the capital to realize it, the exchange of capital investment can form a synergistic relationship creating value for the whole global economy and financial system.
Inversely, negative externalities mean the agents actions deplete from the whole leading to a critical state and collapse. The asymmetry between private gains and the risk to the whole creates externalities. Systems collapse when they become critically fragile due to externalities depleting the resources in the system. For example, when traders purchase an asset knowing the underlying resource is not valuable but believing that the market price will go up, this is a negative externality that over time leads to a critical state as the system fills up with overpriced assets, eventually leading to collapse e.g. a housing bubble.
These externalities can take many forms but they work ultimately to create a mismatch between the level of risk or value of the underlying asset and the level that is perceived by the market. The result of this is a false evaluation which enables over leverage, overexposure and ultimately criticality as smaller changes in sentiment can have larger effects due to the lack of fundamentals. The inherently subjective nature to the financial system and the possibility to exploit that towards the creation of credit where there is no real asset or underlying value creates instability. All of this can be understood in terms of system dynamics, feedback loops, and externalities.
Financial systems operate at all levels from personal finance, to corporate finance, to national, to the global financial system. Complex systems have a scale-free property with structure found at different levels. All complex systems involved emergence and the formation of qualitatively different levels, from the micro to the macro. Agent’s actions on the micro-level create the overall structures and patterns that then feedback to enable and constrain them. Financial markets form complex adaptive systems evolving through an interaction between the overall system and the agents on the micro-level. Actors adopt certain strategies, make investments, those strategies that prove successful become more prevalent in the system while others die out, this changes the state of the system which then feeds back to change the success of the strategies adopted, as agents need to constantly adapt and the whole system changes over time.