derivative

The crucial difference between derivative and value

I covered a while ago the subject of derivatives in “The telephone game of derivatives” but continue to find many so-called experts in the fields of finance, government, innovation and venture feverishly trying to fix derivatives, instead of fixing the real source of the problem. And that flawed focus alludes to either “the experts” not wanting or able to politically engage in fundamental change or a lack of understanding between derivative and value.

I cannot fix political motivations, but I can highlight a better understanding between derivative and value. The dictionary provides an unflattering definition of the word derivative, and perhaps is the reason why the association is not as generously applied as it should.

Let’s ease into financial derivatives with a few more worldly examples:

 

A wedding ring
Someone appears to have made up a rule in the U.S. that as a man heading to the altar you spend an inordinate amount of money on your future wife’s wedding ring to profess your love and devotion. Apart from the ridiculous rule which indicates that love is practically for sale, it says as much about the purchaser as it does about the recipient. Both confuse the one-time occurrence of the wedding with the ability to sustain a happy marriage, the latter which requires constant work and investments in more than just money.

So, the size of the ring is no indication of the health of the marriage. Women who gloat about the size of their ring often don’t about their marriage. The ring, at best is the derivative of the promise for a happy marriage. In reality, the smaller the ring the more likely the young and restless have their eye on the ball.

 

Education
Many of us trot around boasting about our extensive (and often expensive) schooling, especially those with nothing in the real world to hold on to. But schooling is such a small portion of the education you really need to become successful (without cheating) in life.

With a baseline education acquired as a young adult, the real education in life is out on “the streets”. Or as Einstein so eloquently said “Imagination is more important than knowledge”, or as Craig Venter said “formal education stifles innovation”, or as Mark Cuban suggested “the best education my children can get is to travel and go work in a bar”, or as a startup founder recently proclaimed to have to unlearn his MBA to become successful.

Few Americans know and respect anything about the world around them (a trip to Paris doesn’t count) and our effective role in, and a solid understanding of a global economy is perhaps the most sought after skill we need to acquire. What we claim in resumes to be our education, is such a small, incomplete and insignificant part to value people. As someone who has hired many people in business, their schooling grandeur leads me to do a double take on how they would deal with life (and business) unscripted.

The old definition of education is at best a poor derivative to valuing someones propensity to deal with the realities of life (especially in startups). So take off that Ivy league ring if you do not want to immediately alert my bullshit detector.

 

Price
The price of a product is a derivative of its value. Yet price of a product often starts far above the cost it took to produce, to make money selling it. Price is also an indication of the ability of a product to compete. Unique products can demand unique prices, which some manufacturers “abuse” when they have no or limited competition. Hotels for example are notorious for gauging customers when rooms are scarce. So, price is a function of cost to produce times the manufacturer’s ability to compete. Not quite the same as the value delivered to customers.

 

Money
Money is worth more than the paper it is written on. And thus we put more trust in money than we put in the value of its paper. Hence the dollar bills are merely an indication of trust and value, and you will even find out that when that money (paper) is illegally obtained, its residual value is close to zero. More gradual deflation of value happens when money is obtained “easily”.

The person who robs a bank will want to put that money to work “easily” and therefore the trust behind it is losing value. The person who raises a fund “easily” and squanders it may end up with a large house from the fat management fees, but a sole-less existence and an inability to raise more funds if finance was a truly transparent marketplace. And worse, that failure creates heaps of false negatives that subsequently poisons productivity.

Money that comes easily, disappears easily. And money does not by default equal merit. Money is the derivative to value.

 

Venture Capital
Venture Capitalists deploy money from Limited Partners (institutional investors usually) and match that with groundbreaking ideas from entrepreneurs. In the marketplace where money is exchanged for the development of groundbreaking ideas, Venture Capitalists (VCs) operate as the arbitrage and therefore the derivative to the creation of real value.

And just like when a dating site fails to produce satisfactory results and forces you to look elsewhere to find a mate, Limited Partners need to look elsewhere (for new arbitrage) to produce healthy returns for groundbreaking innovation. The governance of the marketplace has failed to produce, not to be mistaken with the unwavering supply of money and ideas. The derivative as the instrument to govern what constitutes innovation is dead, not supply and demand on either side, and thus our ability to recover can be instant.

 

Economy
Expect no significant improvement in our economy when the size of our financial system remains a stunning eleven times the size of production. Most people forget that the financial system itself is the derivative to our ability to produce value. And with the excessive size of our financial system, made up of complex stacks of derivatives, we have become a nation of gamblers on value rather than producers of value.

As a result our economy is systemically unstable and unpredictable. We have stacked derivative upon derivative (probably close to eleven times) to evaluate and therefore commoditize the value of production. Our current production value is already suppressed in no small part by a mediocre financial system.

 

The difference is success
The conceptual difference between a derivative and its value is crucial in determining success. Companies that build on top of derivatives will have a short life span and inevitably have the rug pulled from under them, and its investors are poised to lose their money.

We have built a whole economy on derivatives and as a result will remain fragile until we flatten its construct (rather than mindlessly govern its complexity). Innovation will continue to suffer unless we change the way Venture operates and remove its opulent, in-transparent, unnecessary and counter productive stack of derivatives.

But thankfully in this country we only have derivatives to worry about.

 

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