In a finance class at Wharton, I realized the root cause of the 2008 financial meltdown — complexity.
And if we are not careful, for the same reason, many will get hurt in the current crypto craze.
In the abovementioned class, the professor explained loan derivatives with a simple example. When you repay a home loan, instead of all your money going to the bank, let’s say, you split it into two — party A gets its due first, and the residual, if any, goes to party B.
A and B own what would be called tranches of the loan. And valuing what A and B own is extremely hard because of a zillion unknowns: What if the borrower doesn’t pay fully? What all can impact loan repayment? Recession? Unemployment rate?
In short, it is complicated.
And in 2008, a thousand-times more complex derivatives were happily being traded. Nobody knew what was going on. Any surprise the economy tanked?
Today, I see a lot of people putting money into crypto. Should you do that? I don’t know.
But if you do that, you better understand the underlying value of what you are buying. A general rule of thumb — if you can’t explain something in plain language, don’t touch it.
If not, we are playing musical chairs. In good times, when music is on, we are all happy. In bad times, when the music stops, someone loses their chair.
Instead of predicting when the music will stop, pick another game.
– Rajan
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