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The 7 Marvels of Finance

The 7 Marvels of Finance
Seven great ideas, techniques or methods form the basis of one of the most complex entities we know of today: the financial system.

 

1. Money

Money has liberated humankind from the laborious hassle of barter trading. Exchanging cows for cabbages is not easily done. Money has the following, unique characteristics, it is:

  • Widely accepted as a means of payment (medium of exchange)
  • Divisible in subunits (for instance pound and pence)
  • Durable/storable
  • Convenient, not too large or heavy, portable
  • Uniform in weight and appearance
  • Fungible (the equivalence of each unit of a commodity with other units of the same commodity)
  • Scarce and difficult to produce
  • Stable in value
  • Storage of value

Ideally money is an intermediate medium of payment for an infinite variety of goods and services, as well as a stable repository of value.

Money

 

2. Double entry accounting (first described by Luca Pacioli in 1494)

This bookkeeping technique, in which what is “owed” (debits) is balanced with what is “entrusted” (credits) still is the basis of modern accounting. It reduced the probability of errors. Today’s harmonisation of accounting rules in systems such as GAAP or IFRS would be unthinkable without this bookkeeping method.

 

3. Fiat currency

“Fiat” means “done” in latin. It is currency created by a governmental institution as
the (usually) exclusive means of payment within its jurisdiction (legal tender).

Some economists deny the status of “money” to fiat currencies because in opposition to commodity money (for instance gold coins) fiat currencies have no intrinsic value (a one dollar bill’s paper is not worth one dollar).

That they need not to be backed by an underpinning commodity (gold, for instance), is the main advantage of fiat currencies. This allows for more currency to be circulated. But on the other hand, fiat money requires a credible monetary policy as its value is solely perceived symbolically (the probability to exchange the currency for a stable amount of goods or services at some future moment).

Fiat currency

4. Discounting

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” (attributed to A. Einstein). The reverse of compounding, discounting, is even more wonderful. It allows to calculate the time value of money, and hence to determine the relative attractiveness of investments or projects against a common discount or required return rate.

 

5. Securitisation

This is the transformation of non-marketable assets into marketable financial instruments. Securitisation, is achieved through two forms of transformation:

  • Maturity transformation in which intermediaries (mostly banks) accept deposits of a given maturity, i.e. deposits which are liable for repayment to lenders at a given date, and transform them into loans of a different maturity.
  • Risk transformation achieves risk reduction by diversification of lending, specialist management in screening of borrowers and lower transaction costs.

Excessive securitisation, resulting in opacity of the markets can be threatening to the financial system. This was clearly illustrated by the 2007-8 crisis.

Securisation

6. Fractional-reserve banking

In this system banks hold less reserves than the amounts they lend. In other words banks create debt thereby increasing the volume of both investment and consumption. In fact, the money supply grows beyond the mass of base money issued by the central bank. This banking system is usually underpinned by regulations and monetary policies entrusted to central banks. Most critics of fractional-reserve banking hold that this system inherently leads to a cycle of financial booms and busts. Others point out that fractional-reserve banking is in fact exhausting future resources by excessively encouraging current consumption.

 

7. Options contracts, or options in short

The two types of options contracts involve the right to either buy (“call”) or sell (“put”) an underlying asset at an agreed price (strike price) prior to the expiration of the contract. The options contracts’ cost efficiency and risk mitigation capacity have greatly contributed to the spectacular growth of commerce and finance in the latest centuries. Options also have inspired the development of other derivative financial instruments, such as futures, CDOs.

Option contracts

Critics of the current financial system will argue that these ideas and techniques have lead to a crooked system of crony capitalism. This is debatable, but one thing seems to be sure to me, these inventions are such brilliant examples of the human genius that it is very unlikely they would be given up in any reformed states of financial systems.

By Christophe de Landtsheer

BA International Business

MA International Business Management

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