The global capitalist system is in a state where each individual actor is trying to maximize their own short-term gain, even if it comes at the expense of long-term stability or the well-being of the group.
That often leads to suboptimal outcomes for everybody involved, analogous to the Prisoner's Dilemma problem.
Tip: Use the play button to listen to this article instead of reading
Scroll down, you see I am writing this article to explain the infamous paper "Volatility and the Allegory of the Prisoner's Dilemm" by artemis capital.
In the original problem, two criminal gang members are arrested and imprisoned. Each prisoner is in solitary confinement and cannot communicate with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge, but they have enough to convict both on a lesser charge.
Prisoner A is told that if he testifies against his accomplice and convicts him, he will be sentenced to only one year in jail. If he remains silent, he will be sentenced to three years. Prisoner B is given the same options.
If both prisoners remain silent, they will each serve only two years in jail.
However, if both of them testify against each other, each will be sentenced to four years in jail.
In the prisoner's dilemma, each prisoner has two options: confess or remain silent. If both prisoners confess, they will receive a four-year sentence in jail.
If both prisoners remain silent, they will each receive a sentence of two years in jail. However, if one prisoner confesses and the other does not, the prisoner who confessed will receive a sentence of only one year in jail, while the prisoner who remained silent will receive a sentence of three years in jail.
Each prisoner must choose whether to confess or to remain silent without knowing what the other prisoner will do. If both prisoners confess, they will each receive a sentence of four years in jail.
In the global capitalist version of the Prisoner's Dilemma, the two "criminals" are central banks, and the goal is to manipulate the cost of risk in a way that benefits one's own country.
· The Bretton Woods system ∘ What if interest rates were to rise suddenly? · The tools of money are suppressing the truth. · moral hazard · Volatility · Shadow convexity · Short volatility products · Convexity & Shadow convexity
I'll use the paper by Artemis Capital, "Volatility and the Allegory of the Prisoner's Dilemma," as reference material on which this article will be based.
Well, actually I try to convey what their paper is explaining since it's complicated
You can find the link to the paper in my linktree pdf section: https://linktr.ee/romanornr
That part is only 12 lines of text, but there's a lot to unpack since everything is so abstracted away.
The first time I read this paper was in the winter of 2020, and I started writing this article in September 2022
I only publish it now because I kept it in the drafts, unmotivated to continue writing it. I sometimes see people link this paper, but I'm sure most won't understand 50% of this paper. I figured I might as well post it; everyone can continue to read the original paper independently.
The Bretton Woods system
In 1944, the Bretton Woods system was established to regulate the global economy. Under this system, each country's currency was pegged to the US dollar, and the US dollar was pegged to gold.
Bretton Woods system lasted until 1971 when the US dollar was no longer pegged to gold.
Since then, central banks have been engaged in a "race to the bottom" regarding interest rates and devaluing their currencies. Central banks have been trying to lower the value of their currency relative to other currencies.
The reason they did this is that central banks are seeking a lower cost of borrowing. By devaluing their currencies, central banks can make borrowing money cheaper for citizens and businesses. That gives them a competitive advantage over other countries with higher interest rates.
Suppose global central banks do not devalue their currencies while other central banks try to devalue their currencies. In that case, the central banks that do not devalue will find themselves at a competitive disadvantage.
They will have to pay higher interest rates on their debt, making it more expensive for their citizens and businesses to borrow money. That could eventually lead to a currency crisis, as investors lose confidence in the central bank's ability to maintain its currency's value.
That "race to the bottom" has led to a situation where there is less and less opportunity for investment and growth.
Since it has led to a build-up of debt and leverage and widening income inequality, there is a danger that this situation could lead to a "tail event" — that is, a financial crisis — on a global scale.
That is because the indebtedness of both households and governments makes them vulnerable to changes in interest rates.
What if interest rates were to rise suddenly?
If rates were to rise suddenly, many debtors would be unable to meet their payments, leading to defaults and a financial crisis.
The only way to avoid this outcome is for central banks to cooperate rather than compete to appropriately manage the cost of risk.
However, this is difficult to achieve in practice, as countries are often reluctant to sacrifice their short-term interests and cooperate for the sake of global stability.
However, if they defect, they can trigger a financial crisis. That creates a dilemma because each central bank has the incentive to defect to gain a competitive advantage, even though it is in the best interests of the global economy for them to cooperate.
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The tools of money are suppressing the truth.
One of the problems with global capitalism is that truth is often suppressed in favor of profit.
For example, corporations might ignore environmental problems to keep costs down or hide information that could damage their reputation.
That can lead to a situation in which the public needs to be fully informed about the risks of investing in a particular company or the potential impacts of a particular policy.
Tools of money can also be used to manipulate public opinion.
For example, corporations might use marketing and advertising to distort the facts about their products to sell more.
They might also use their financial power to influence policymakers or buy up media outlets to control the narrative. All of this makes it difficult for the public to make informed decisions about where to invest their money or how to vote.
The problem is further complicated by the fact that markets have now fully adapted to the expectation of pre-emptive central bank action to the crisis, creating a dangerous self-reflexivity and moral hazard.
Central banks manage a country's money supply and interest rates. They often take action to stabilize the economy during periods of financial stress.
One of the problems with global capitalism is that markets have now fully adapted to the expectation of pre-emptive central bank action in a crisis.
That means that markets constantly anticipate central bank intervention, creating a feedback loop that can amplify market swings and make financial crises more likely.
This means that because markets expect central banks to take action during periods of financial stress, this can lead to more extreme market fluctuations and an increased likelihood of financial crises.
That is a problem because it creates a "moral hazard."
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moral hazard
A moral hazard is often thought of as a problem that arises when people are protected from the consequences of their actions.
For example, a bank may take on more risky loans because it knows the central bank will bail it out if it gets into financial trouble. That can lead to a situation where people take more risks than they would otherwise, eventually leading to a financial crisis.
There are a few different ways to think about moral hazards. One way is to think of it as a problem that arises when people are not fully accountable for their actions.
For example, if a bank knows that the government will bail it out if it gets into trouble, it may be less careful about making loans, which can lead to a financial crisis.
Another way to think about moral hazard is to think of it as a problem that arises when people are incentivized to take more risks than they would otherwise. For example, if a bank knows that the government will bail it out if it gets into trouble, it may be more likely to take risks to make more profits. This can lead to a financial crisis if the risks don't pay off.
A moral hazard can be a problem when people are not fully accountable for their actions or have the incentive to take more risks than they would otherwise. It can lead to financial crises and other problems.
Volatility
Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior.
Volatility markets are markets in which investors trade financial instruments that bet on the level of market volatility.
The markets for volatility derivatives are highly unstable and tend to make sudden, unpredictable changes. This is because the underlying asset that these derivatives are based on, namely market volatility, is itself highly unstable. In other words, the markets for these derivatives are exhibiting the same schizophrenic behavior as the asset they are based on.
One reason why this is happening is that the global economy has become more interconnected than ever before. This means that when there is a shock to one part of the world, it can have a knock-on effect on other parts. For example, a stock market crash in China will likely lead to increased volatility in other global markets.
Another reason for the increased market volatility is the growing use of high-frequency trading. This is where computer algorithms are used for trading in and out of assets at very high speeds. This can exaggerate price movements, as well as lead to sudden, sharp changes in prices.
The upshot is that volatility markets are very difficult to predict and manage. This can be problematic for financial institutions, as these markets are an important source of revenue. Financial institutions are often betting against (shorting) volatility, which gives them limited upside but potential unlimited loss.
Betting against volatility might work 9/10 times, maybe 99/100 times, but there's that one time you'll lose your shirt "institutional style." Even when delta hedging, the exposure can be difficult during a black swan event.
Shadow convexity
The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, creates a dangerous 'shadow convexity' that can fuel a hyper-crash.
That is because self-reflexive investment strategies amplify this growth's effects, leading to increased fragility in the system as a whole.
In other words, the short volatility complex is growing at an alarming rate, and self-reinforcing investment strategies exacerbate the situation. That combination could lead to a massive market crash, as investors are forced to liquidate their positions in a panic.
Shadow convexity refers to the amplified risk when investors are over-exposed to volatile assets.
That risk is often hidden or 'shadowy' because it is not always obvious to investors how much they are actually exposed to it. However, when market conditions change, and these hidden risks are revealed, they can lead to sharp losses.
The short volatility complex is a key driver of shadow convexity, representing a massive build-up of exposure to volatile assets.
When this complex starts to unravel, it can trigger a rapid and dramatic sell-off as investors scramble to get out of positions that have suddenly become very risky.
Self-reflexive investment strategies can exacerbate the effects of the short volatility complex by amplifying market moves.
These strategies can include hedge fund managers sharing their positions with each other or using leverage to increase their exposure to volatile assets.
The combination of the short volatility complex and self-reflexive investment strategies is highly dangerous and can potentially fuel a major market crash.
Short volatility products
Short volatility products are financial instruments that bet on low levels of market volatility.
An example of a short volatility product is the SVXY. The SVXY is an exchange-traded fund that bets on low levels of market volatility.
Another example of short volatility product is the XIV Exchange Traded Note (ETN). The XIV ETN is a financial product that bets on low levels of market volatility.
The problem is that when volatility does eventually spike, as it did in early 2018 (Short-volatility Armageddon), these "short vol" products can lose a lot of money very quickly, amplifying market swings.
These factors create a dangerous situation that could lead to another financial crisis.
Self-reflexive investment strategies seek to profit from market trends that have already been established. These strategies can amplify market swings because they can add to the buying pressure when prices rise and the selling pressure when prices fall. The self-reflexive investment strategies used in the short volatility complex also add to the risk of a financial crisis.
These factors create a dangerous situation known as "shadow convexity."
Convexity & Shadow convexity
Convexity is a measure of the curvature of a financial instrument. It is used to determine how the price of an instrument will change in relation to changes in the underlying interest rates.
In general, the greater the convexity of an instrument, the greater the price movement will be in response to changes in interest rates.
That is because instruments with greater convexity are more sensitive to changes in interest rates.
A financial instrument is said to have positive convexity if the price of the instrument increases when interest rates rise and decreases when interest rates fall.
A financial instrument is said to have negative convexity if the price of the instrument decreases when interest rates rise and increases when interest rates fall.
Shadow convexity is a situation in which the risks of a financial crisis are underestimated. That can lead to a situation in which a financial crisis is more likely to occur because people are not prepared for it.
Shadow convexity can occur when a build-up of risk in the financial system is not adequately accounted for.
That can happen when there is a lot of debt in the system, leverage, or speculation. All of these factors can contribute to a financial crisis, and if they are not adequately accounted for, it can lead to a situation in which a crisis is more likely to occur.
Central banks in the US, Europe, Japan, and China now own substantial portions of their own bond and equity markets. That means they are effectively propping up their own markets by buying assets.
We are nearing the end of a thirty-year "monetary super-cycle" that has created a giant tower of debt. The monetary super-cycle is a period of time in which central banks have kept interest rates low and printed money to stimulate the economy. That has led to a build-up of debt, and now we are nearing the point where this debt will need to be repaid.
As markets now fully price the expectation of central bank control, we are only one voltage switch away from the next financial crisis. That is because markets are now fully anticipating central bank intervention, creating a feedback loop that amplifies market swings and makes financial crises more likely.
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[UNFINISHED DRAFT]
I may edit this article since I am unhappy with it, the reason why I kept it in the draft for so long
There's a lot to unpack. I don't know the best approach for a 2–4 hour full article or in parts.
I'm not sure if I will continue working on part 2. If there is interest, maybe. It takes too much time.