Some people consider fractional reserve banking systems and maturity transformation little more than a glorified Ponzi scheme. While there is a certain truth to this view of the world, I think it is more appropriate to understand that the financial world is designed around coordinated rather than competitive equilibrium.
Market infrastructure was traditionally organized by a club of wealthy families. The advantage of the “club” is that it was not particularly difficult for the members of the club to join together to take actions that were in the interests of the whole club. On the one hand this preserved their wealth in the form of very comfortable fees, but there also wasn’t so much of a need to “keep dancing” because competition was limited, the danger of instability was well understood and everybody recognized that nobody’s interests were served by competition that was likely destroy the value of the club as a whole.
While it’s easy to demonstrate that this was far from a perfect world, the question I want to ask is whether it is possible for an all out competitive financial system to have the same measure of stability that was possible when finance was organized as a club.
What precipitated these thoughts was Economics of Contempt‘s defense of fierce competition between trading venues. While I understand that this is taking place, I’m much less confident that this competition is valuable. I wonder whether we wouldn’t be better off with a single venue where all trades must be coordinated (the exchange). Yes, this is inconvenient for those with big orders who want to hide them — but isn’t it an important principle of economics that their supply or demand should be affecting the market price so that everyone can see and respond to it?
Too much emphasis has been placed in recent decades on encouraging competition in financial markets. Perhaps it is now time to focus on the role that coordination plays in maintaining the stability of a system with built-in instability.