Financial Instrument and the Future of Financial Theory

Moscow, August 28, 2019 — Business Systems Consult. What principles govern the modern financial system, what are their conditions, what may change and what is the role of IFRS 9 in all this staff.

The Nature of the Financial Instrument

Financial instrument is an analytic style for finance and economy, the way of information processing in the system of exchanges. The modern understanding of the financial instrument is described in the previous article. The basis for it is a set of artificial assumptions. They are changing with time, and this changes the financial system.

1. The Problem of Valuation Is Correct,

that is:

• valuation for any instrument (not only financial ones) exists: everything may be valued in money equivalent,

• valuation for any instrument is unique,

• valuation for any instrument depends on initial data and conditions continuously.


• In practice, there are instruments that cannot be valuated; ecology cannot be regulated with Pigou taxes (that is, the compensation of ecological damage through financial methods is ineffective), the infrastructure is often invaluable.

• Even in paradigm of financial instrument, the similar instruments may have significantly different valuations.

• A ship in technical readiness of 95% is valuated at scrap-iron cost (approximately at 10% of its cost); technical readiness of 100%—at full cost.

• A high valuation of collateral property is not a reason to wish to replace a loan with it (as IFRS 9 may lead to).

2. Valuation Is Short-Term:

Valuation of a financial instrument decomposes to the present moment under going concern scenarios and reflects point-in-time conditions and “flat” expectations (stability, stationary economic conditions or myopia of analyst).

However, short-term nature of valuation process does not take into account risk maturation or long-term risks:

• the major problem in capital adequacy of Russian retail banks during crisis of 2015 was caused by risk maturation: the need for capital grows, the restricted new deal volumes do not solve the matured risks, it is impossible to sell the loan portfolio;

• the stripper carriage, a carriage for wide steel sheet, the material for large diameter pipes, is carriage in large demand… until the Nord Stream project of gas pipeline is finished, that is for the next 3—5 years, after that period these carriages (constructed for exploitation for 30 years) will not be demanded;

• the borrowers from the hell: sometimes lending should be directed at bankrupts; for example, the Anglo-Persian Oil Company was beyond the bankruptcy in 1900—1914, and even the replacement of coal with heating oil as a fuel for the Royal Fleet did not help it.

3. Cross-Default

If a borrower fell into default (as a rule, past due for 90 days, see §452 of Basel bcbs128 or p. B5.5.37 of IFRS 9) for one of its deals, the default is recognised in any other deals. This leads to the possibility of separate analysis of a borrower and a deal (the seecond principle of distinction).

However, the practice of project finance the special purpose enterprise immunises the project initiator from cross-default. Financial leasing, in contrast, has a very sharp difference. The economic inefficiency of one particular type of carriages (for example, black dirty tank cars in low oil price environment) does not reflect te problems with other types of carriages (for example, hoppers ). Cross-default recognition forces the lender to cope with carriage operation, logistics, transport industry organisation, to solve the problems of carriage parking. It is not an equal change for financial instrument concept!

4. The Prevailing Technology of Exchange

The current prevailing technology is a burse. The investors have access to the full list of traded instruments (especially termed contracts) which can be settled either in cash or in natural form without any material difference for the counterparts. Hedgers are able to close their risk positions, speculators provide fair and flexible pricing.

However, in practice this technology of exchange is mainly restricted to the North American markets. Even there its functioning is subject to the access to liquidity. The Metallgesellschaft Refining and Marketing case demonstrates the drawbacks of the mechanics of financial sector. This explains the superior role of financial sector in profit distribution in the modern economy. How this technology stops its functioning and who keep the bank is discussed in a separate article.

5. Standartisation of the Law

However, from the microeconomic point of view, any rational economic agent respects the law or contract conditions if and only if it is profitable for him or her. In other words, observation of regulations s a result of Nash equilibrium (that is, nobody cheats alone), perhaps, in repeated games.

On the other hand, the property rights should be supported by solid arguments on a constant basis. Otherwise, these rights are neglected and imaginable.

Memoirs and Fantasies

One of the main instruments for analysis of development is dialectics. Its law is the unity and struggle of opposites. As for the development, unity is reflected in trends, in acquiring achievements, but not in declining achievements:

“Progress is a unity of qualitative and quantitative changes, the unity of continuity” (see the textbook “Materialistic Dialectics. A Short Review of the Theory” by P. N. Fedoseev, I. T. Frolov, V. A. Lectorskiy, V. S. Schvyryov, B. G. Yudin., Moscow, Politisdat, 1985.— 350 p., p. 74, in Russian).

Struggle of opposites is realised in negation of negation, transmitting from any quality to its negation. But development through negation is discerned not as a transformation from white to black, but as a transformation from black-and-white (black or white) to colourful.

The characteristics of the financial instrument enlisted above were originated through the modifications of the properties of money (that in this context are defined as compact, relatively rare and valuable pieces worthless in consumption as well as debt notes of respectable market participants, which are considered as a money equivalent in accordance with fiat or market practice). By analogy, financial instrument development to any other medium of exchange may be described as extrapolation of its properties.

So, several trends may be fixed.

1.  Money functioned in various legal frameworks. In particular, various fiats defined in various jurisdictions various debt issues as money.

One dialectic extrapolation of this principle to the financial instrument is a deviation from universality of legal framework across the World (that is a characteristics of the financial instruments concept). To some extent, it is a move back to the money legal framework (unique for any particular jurisdiction). In the same time, the regulations in fragmented legal frameworks should cover the innovations encapsulated in the concept of financial instrument.

An interesting point is who is the source of regulations. In a world of money, the sources of regulation were the government legislators. In a world of financial instrument, the source of regulation was the complex of supranational agreements (like Bretton-Woods) and bodies (like Basel Committee). In a post-financial instrument world two tendencies are being observed.

• The first one is a fragmentation of the regulations to the different currency worlds corresponding to different sovereigns and their satellites. Moving this way, the system simply returns to the world of money but with te financial instrument as a medium of exchange.

• The other one is moving the exchanges to different platforms (usually based on the blockchain technology). In this variant, the rules of these platforms become the new legislation. The platforms  themselves are the new legislators of the financial system.

In any case, institutional investors create various instruments (independent from the present ones) of legal enforcement in their property rights. These instruments include own IT and communication networks, security services, accounting institutions for property rights, arbitrage courts etc. For example, Chinese investors who finance the infrastructure projects overseas, combine the agreements that in some interpretations may be considered as exterritoriality agreements. A railway in Laos is an example of the zone of exceptional economic interests.

2. Prevailing technology of exchange in a world of money is bilateral (sometimes multilateral) agreements (sale contracts). These contracts may be long-term with fixed conditions or some restricted volatility of these conditions. Burse is a technology of exchanges in a world of financial instrument. Its crucial part is marking to market that leads to the short-term nature of any agreements. All the contracts are standardised, but the number of standards is very restricted to simplify clearing. The further development may lead to the return to the long term bilateral or multilateral agreements of money world. From the world of financial instruments these agreements will inherit standartisation. However, the number of standards may be quite large (even one standard per contract)—the modern computation power allows it and can support the complicated clearing. Quantum computing will further improve the productivity of this system.

3. Cross-default. In a money world default in some obligations did not lead to the exclusion from the exchange system. In other words, there was no cross-default. Financial instrument concept takes cross-default as its essential part. The return to the bilateral agreements cancels cross-defaults. Development of escrow mechanisms (basing on the new information technologies for agreement administration) will facilitate risk management. The problems with profitablity of some business lines will be being solved massively and pragmatically. The borrowers from the hell are back.

4. Short-term nature of valuation. In a money world, a deal was in a focus. In a world of financial instrument, attention focuses on the profit recognised at the deal initial recognition. The future focus will get back to the deal. In particular, net interest income will be more important than net present value. Flows will be more important than artificially engineered stocks again.

5. (In)correctness of the valuation. Like in a money world, valuation will lose its significance. Accounting will bee conducted not only in a money equivalents but also on a natural basis. Fortunately, information technologies allow to do it.

This accounting may lead to interesting consequences. Some data of the late 1990s show that the total volume of energy required for a solar battery to produce and utilise upon the service term exceeded the volume of energy this solar battery extracted for its lifetime.

However, valuation procedures continue to cover all the instruments, unlike in a money world where valuation dealt with traded goods only.

On the Eve

Development of economic institutions gives birth to the new economic theory. New economic theory has to create a new financial theory. This theory has to:

• provide long term (for the deal lifetime) forecasts for financial and risk measures;

• deal with different accountings (simultaneously in money equivalent and in natural equivalents);

• get along without risk-free instruments, cross-default, and no-arbitrage conditions;

• institutionalise the mechanisms of working with borrowers from the hell;

• create methodology for financial analysis which will take into account the characteristics of the real assets.

It is worth to note that the fully functional implementation of IFRS 9 and Basel III without errors, simplifications, or restrictions making the business inefficient, stimulate to create this New Financial Theory. The former achievements of the Old Good Financial Theory should be reassessed but taken, improved, and realised in a new quality basing on the technologies emerged, reflecting the realities of the new-being born economy.

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Comments: 2
Опубликовано 28 Aug 2019 Author Magister ludi

by wuTJbcie @ 15 Jan 2020 02:19 pm
by XRfGbwzmWt @ 02 Jul 2020 04:49 pm
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