Clash Of Titans: The Rise Of Finance

We live in a fascinating era. Technology and science move at an incredible speed and the forecasts about the next big thing are a common buzz in our daily lives. As Mark Twain wrote:

“Prediction is very difficult, especially if it’s about the future”

Technology, connectivity and globalisation had more impact on humankind for the last 20 years than centuries of human development. Before looking at what the future of finance might look like – and dive into scenarios such as decentralised payments and settlement systems, peer-to-peer lending, crowdfunding, robot advisers and riskier trading as financial transactions become more electronic, we must first understand how we have gotten here. To be more specific, what and where developed the building blocks of the advanced methods and ingenuity that are core to the financial activity and allow Men to pursue projects that without finance would have never been possible.

Although we can trace the beginning of money to 600 B.C., when Lydia’s King Alyattes minted the first official currency, the tipping point arises with the Inca decline – pushed by the Spaniard conquistadores. The Incas had no real concept of money, labour was the true unit of value. In 1532, fueled by a hunger for money, Francisco Pizarro from Spain arrived at upper Peru inspired by the tales of the existence of El Dorado. Soon after his arrival, Spaniards discovered the rich hill (the Cerro Rico) at Potosí. The Incas didn’t understand the lust from the Europeans for gold and silver. The mines explored allowed the creation of coins, a measure of account, objectively portable power. These quests had the goal to finance their expeditions and the European crown. But across the ocean, the empire was declining, mostly due to the devaluation of the coin. Money is about trust as long as the recipient sees it, Spaniards failed to see this. Innovation, a word derived from the Latin word crato (I believe), more specifically financial innovation had its more fundamental birth with the invention of credit.

Without this invention, the finance world as we know it would not be possible. This allowed fundamentally the flow of goods. Moving to Northern Italy, trust was in short supply. Numeric system, in Pisa transactions, were a disaster (Muslim and Chinese empires were at the time more advanced), until the mathematician Leonardo Fibonacci developed the sequence of numbers, a system that mimics nature behaviour. The book of calculation proved the superiority of Arabic numbers compared to Roman numbers. Fibonacci showed how the new system could improve commercial transactions, exchange rates among others. Venice was more exposed to the east and as a result became a laboratory for financial innovation. Credit worthy, a term coined in Venice that had the meaning “he is sufficient”, as seen in the literature of the time. Without this new innovation in medieval Italy, loans could go wrong, ships could be sunken. Compensation had to be made, the payment of interest to compensate the risk started to be adopted. Looking at some literature from Shakespeare from the time, one can relate accurately the use of the expression “a pound of flesh” to capture this system. In Venice, Jews who stayed in for more than two weeks had to wear a yellow hat. The rise of the importance of Jews in the financial activity was mostly because they could provide a service that others could not, i.e., provide loans and collect interest. Merchants had to go to the Jews to get borrowing because the Catholic Church considered the activity a sin. Dante Alighieri on one of his works – Hell, dedicates a part to describe this activity performed by the Venice Jews, were money lenders were tortured. The real and raw association that people have a tendency to associate Jews with finance goes back to the creation of the so called Ghetto clause, chapter 23. This clause prohibited Jews to lend among themselves. This service resulted in exclusion and its why Jews since that point were associated with finance.

One of the most important building blocks of finance came with the invention of Banks. In the 15th century, Italy moved out of the ghetto type activity to banks. This strategic shift is best symbolised by the rise of the Medici, with which money became glorious, a new form of power. Just as an example, two of the Medici became kings, three became popes. It is safe to that The Medici were, by far the biggest mark of the Renaissance, from Michelangelo to Galileo… The Medici started as loan sharks competing with a small clan from the time – the Sopranos. At the beginning, the Medici were foreign exchange dealers and saw five of their own be sentenced to death, related with their obscure activity. Until Giovanni di Medici came into play, introducing a new financial innovation that gave them an absurd level of accumulative power within a short time frame – the introduction of commercial bills for transactions under multiple currencies.

There was no interest but only commission. By introducing the commission concept, and not using the “interest“ jargon, this activity was not censored by the Catholic Church. There was no sin, so to speak… This was a smart and elaborated idea that allowed to conceal the interest payment, a kind of evolution that was called Banking. Medici believed in the power of decentralisation and diversification to lower the default risk. This approach made them astonishing powerful. With wealth came power. Politic questions were decided at the Medici house. An author of the time uses the expression ‘He is king in everything less the name’ to characterise Giovani. In roughly 150 years the Medici transformed themselves from loan sharks to the most powerful financial force in Europe. The birth of modern banking was primed by the Medic strategy of diversification and by focusing on the exchange that allowed them to be protected from default by the obligations of their customers. Modern bankers thought they were smarter and eluded the problem of default. The spread of banking in the US – that, by the way, was built by the lending money process, and the easy credit ‘subprime’ crisis was a king of Pizzaro’s Eldorado (history repeats itself).

In subprime America defaulting on their subprime is easy. Repos did and still do the same as the shark loans did, capitalist most successful nations are based on financial failure. Bankruptcy in mediaeval Italy was considered a disaster and might ended in death. On the other hand, in America, it’s a normal and a right in modern America. The American Constitution empowers entrepreneurship and states that the people are entitled to a second chance… A theory some say! Some great figures have flourished because they failed and had been given a second chance to flourish, Henry Ford as an example, among many others. Credit and debt are the building blocks of modern finance. Borrowers have to have access to idle funds and supply have to be efficient. But why have banks collapsed, how banks have busted in recent years? Being a bank was at some point a very boring activity, but a series of financial innovations have given a thrust of alchemy. Modern banking has in its original DNA the bond market. Bonds are the magic link between the world of finance and the political system.

After the rise of banks, bonds were the new El Dorado. Bonds funded wars – waterloo, def the at of the south on the American civil war, the crash of Argentina – Governments borrow, that’s a fact. If in today’s world the bond market crashes, all economic activity – directly or indirectly, is seriously shaken. Bonds are a shelter on a crisis. Looking again at medieval Italy, war was at its higher stage – internally and abroad. War is impossible if you don’t have the money to pay for it, and here again, Italy saw the invention and rise of financing through the bond market. The bond financing was an invention of medieval Italy. Mercenaries were available to fight for who paid the most, switching sides easily, depending on whose hands was the money. Deficits came to arise in Florence. Debt exploded, the Medici had borrowed from themselves continually – until the bond market invention took place, citizens were obliged to borrow to their governments and in return, they received interest from that ‘forced’ loan. Bonds were liquid assets. Florence made their citizens investors. This brilliant idea had one problem, there was a limit to this idea, more wars implied more issuing of bonds and as a result, the bonds were perceived in the marked as less valued. And as such, they had to trade at a lower value than the face value of the bond. In a sense, the bond pays the risk perceived. The bond market was invented to help Italy pay for its wars, but evolved far beyond its original purpose, that is to say, bonds evolved to the modern design and application of bonds.

Moving forward, the Bonaparte of finance arises not far from medieval Italy. Nathan Rothschild, the third of five sons of a ghetto Jewish family, described as short, obsessive and extremely focused, rises to obtain an unparalleled power in finance. Nathan the third son, the most ambitious of the five brothers, moved to London. He had the work ethic, his only pleasure was his business – as described by a member of the family. This phenomenal drive and genius gave him mastery of the growing London bond market. But it was the war that made Nathan powerful. The battle of Waterloo was more than a battle of two nations, but for two financial types of finance, plunder and bonds, the Rothschild’s toke advantage of speculation to misreport the outcomes of the battle to London. The mayhem created in the London bond market made possible to Nathan, selling tonnes of bonds, reunifying tonnes of money raised from the bond market and giving it in the form of gold to finance war. Nathan was later made an English agent that had at hand the ability to mobilise gold from its European family network, charging handsome commissions.

The Rothschild’s were so effective in war finance because of the synergies of their familiar pan-European network, selling and buying depending on the local value of gold. This was a great advantage. Information was key, Nathan received the news about the battle almost 48 hours earlier than the official news. With this inside information, privileged, he knew that the price of gold would fall according with the public perception. A risky bet he did, a massive bet on the bond market, he massively bought British bonds, and as a result, the price began to rise and he continued to buy for almost a year. After a 40% accumulative gain, he sell. Bonds could be bought and sold to earn heavily sums of money, and with this came power and at some point also, the Rothschild’s became hated, based on anti-Semitic precedents, this is to say, because of their Jewish connotation.

The most indignation came from the public perception of their association with war finance. The Rothschild’s were at this point fund managers, by diversifying their portfolio on a global scale. Once again the bond tycoons were the makers of wars. On the other side of the Atlantic, in the new world, 50 years later a new war was decided by the bond market. The American civil war. Fast forwarding to today, the 21st Century Rothschild of the bond market, Bill Gross only cares about the impact of inflation. Risk management, is the heart of modern finance. But unlike Nathan, Bill Gross started earning money, not in finance, but playing blackjack at Las Vegas…

Some argue that the most impactful financial invention was the stock market. The willingness to pay for a company stock shows the future prospects of the company as seen from the buyers’ lens, supposedly the sum of discounted future cash flows… The future is uncertain, but humans are chemically charged with euphoria, and when it reaches its peak, irrational exuberance takes control. Enron was the biggest corporate fraud known to men. How difficult human find to learn from history… Again in Venice relies upon of the most spectacular financial crashes actors, John Law (history first great crash). Many of the stock players followed his steps. Law escaped from prison and run to Amsterdam, the world capital of financial innovation at the time. From the Netherlands come the most spectacular of inventions, the limited liability company and the stock market. Asia was the target of Dutch expansion. The Dutch plan was getting faster to Asia by sea. To fund such an ambitious plan they had to pull their resources and share their risk together. They came together to fund the Dutch East India Company (VOC). The structure was novel, citizens were invited to invest in an unprecedented type of financial asset, in the form of a share. The share was a promise to pay the holder a slice of future profits from the endeavour. After it was declared that investors could not receive the money directly from the issuers, but only by selling to others participants in the market. The stock market was born.

Bankruptcy in the US had the largest impact in 1929, in the well-known black Thursday. The asset deflation output collapsed by a third, a quarter of the labour force was affected. Why do financial crisis happen? Beyond technical explanations, comes the raw psychologic reasoning. Irrational exuberance… Bull and bear associated with mood feelings. Buyers become sellers, bulls become bears… Complete breakdowns occur more often than suggested. Seven such crisis in the last century suggests that the static and mainstream theories have limitations and can’t explain mainly the growth and impact of crisis in the modern ages. On the other hand, crisis gave a great opportunity – the claim of wealth. As an example, Enron the biggest scandal, the biggest tail so to speak. It pioneered a series of practices that still are available today. Enron was the ‘pretty girl’ of Wall Street. And for that pretty girl, as Shakespeare mentioned, a huge pound of flesh was paid…

Looking at the Far East earlier in the last century, the Japanese economic appetite inspired the foundation of the welfare state. The main goal was to seduce soldiers to enlist in the military to help the emperor establish the empire. The problem was going against the US colossus. The Japanese economy collapsed at the hands of US. Kyoto resisted but the lesson was clear, insurance was part of welfare, and the state had to step in. Not only by this financial innovation is Japan known. Centuries before, the invention and rise of the futures market took place in Japan.

The objective of this piece is not to go in depth in any way about the current financial sector. Neither the objective is to talk and use jargon and technical tools. That will be a discussion for a future opportunity. Swaps, Repos, DCF, M&A, Leverage, and thousands of other key definitions that are crucial in today’s world, are a result of centuries of innovation and ingenuity from men, like us, that at some point in history have built the building blocks of what finance today is all about – solving problems, and advancing welfare. As in every field, failures and lack of ethic are common. But, that is part of the game…

Learning the financial tools available today are at the end of the day, not so hard to develop. Education and experience will equip an individual with the right tools. But to understand the bigger picture, one has to dive into the creation of the “beast” to have a competitive advantage and ultimately to find one’s purpose in the world of finance.