Capitalism just like Adam Smith pictured it

From far away, things that are very different look alike. I grew up in a family of musicians and English professors. To them, the entire financial industry seemed corrupt. When I worked in finance – first on Wall Street and then in venture capital – I saw that the reality was much more nuanced. Some finance is productive and useful and some is corrupt and parasitic.

Most financial markets start out with a productive purpose. Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas, for example for airlines to hedge their exposure to oil prices and transnationals to hedge their exposure to currency fluctuations. The sellers of these derivatives were aggregators who pooled risk, much like insurance companies do. The overall effect was a net reduction in risk to our economy without hampering growth and returns.

Then speculators entered the market, creating more complicated derivative products and betting with borrowed money. This was defended as a way to increase liquidity and efficiency. But it came at the cost of making the system more complicated and susceptible to abuse. Worst of all, these so-called innovations increased the overall risk to the system, something we saw quite vividly during the recent financial crisis.

Venture capital is a shining example of capitalism just like Adam Smith pictured it, where private vice really does lead to public virtue. Consider, for example, two of the largest areas of venture investment: biotech and cleantech. Here we see the best and brightest – top science graduates from places like MIT and Stanford – devoting their lives to curing cancer and developing new energy sources. These students may be motivated by good will, but need not be, since they will also get rich if they succeed.

A strong case can be made that the financial industry needs significantly more regulation, particularly around big banks and derivatives markets. But it would be a tragic mistake to create regulations that hinder angel investing and venture capital. From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.

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jwaller

Great post. I think a big difference is the time horizons in which the VC industry and Wall ST. work. VC funds have a 10 year life, w/ a slow maturation. Wall St. work towards quarterly or at most annual horizons. Therefore, Wall St. has the ability to take (or create) long term risk for a short term gain (see The Black Swan). The *true* risk simply isn't properly calculated. Because of the long term nature of VC, the ability profit in the short term from taking future risk is lessened (the late 1990's bubble not withstanding… Although even this was facilitated by Wall St.).

http://www.cdixon.org chris dixon

I agree. The focus on quarterly results is extremely damaging. Sometimes I think there should be a 90% tax on short term capital gains and no tax on 5 years capital gains or something extreme like that to make the public markets more like the private markets.

Ciprian Patrulescu

I like the idea!
http://www.victusspiritus.com/ Mark Essel

Haha, that would be quite amazing. But you know the short term sharks would find a vehicle to abuse that well intentioned idea.
Riz Tarded

Chris – You're a smart guy but this idea which I hope you were throwing out there to be provocative is riz-tarded (channeling my inner Jay-Z). The private markets, if there is such a thing as a private “market”, is opaque and highly highly imperfect (proprietary deal flow anyone?). The VC track record shows how picking winners is difficult and so the private market you speak of is really not a good example or model to follow.

And if one of your founder's collective investments went public, you'd want to be locked up for five years? Or I assume they should make some exception given you invested when it was private?

I agree Wall Street has got many issues but the idea of increasing taxes on people based on duration of holding is inane. The issue is corporations manage for the short-term and so that should be addressed (I don't really care to be honest as it's their choice) through proper incentives of management, boards, etc.

90% cap gains – jumped the shark on that one.

The ODB

http://www.cdixon.org chris dixon

Somehow I have trouble getting upset when a guy calling himself “riz
tarded” says I jumped the shark.

Riz 3

Ha nice Steven Seagal dodge there. Easier to pick on my name than actually thoughtfully respond to my comment I suppose?

Any fanboys willing to explain how Chris' logic on the 90% short-term cap gains makes any sense?

http://www.cdixon.org chris dixon

LOL

Riz T

Oh well – was hoping for a legit response but alas…

For those keeping score at home…

Riz Tarded: 1
Chris Dixon: 0

http://stevecheney.posterous.com/ steve cheney

uh this is classic.

the guy attacking mark essel and Riz Tarded are the same guy per disqus

http://disqus.com/guest/3e01bc0736efbc28c6856a6…

Riz To the Arded

Steve – Some pretty slick Sherlock Holmes/CSI work there. Bravo.

I wasn't attacking Mark but was perplexed. He skillfully handled my jabs so he's earned my respect (which I'm sure he was very desirous of)

Chris – on the other hand couldn't handle what the Riz was cooking hence the radio silence. He can admit his 90% short-term cap gains comment was a provocative but ill-advised idea. Folks will still read his blog even if he admits he was wrong.

There's a first for everything, right Chris?

ablanaru

Having transitioned from Wall Street to the tech entrepreneurial world myself, I completely agree with your points and have a very similar view.
When it comes to the regulations they are proposing, I have strong empirical evidence (from my years dealing with the “high net-worth individuals”) that most of them cannot understand the risks of investing in VC any better than a 20 years old kid studying engineering. I would actually argue that in many cases, the kid has an even better comprehension of what is involved, especially because many of 'qualified investors' are stuck to the old ways.
That is, the regulation they propose not only wrongly puts angel and VC investing in the same bucket as some speculative practices, but is also 100% ineffective from the perspective of what they are trying to accomplish.
It's time to think about alternative ways to define who is qualified for a certain type of investing or not (It could be an exam or something else that demonstrates knowledge. Simply having money doesn't mean you know a lot about it. It means that you know a lot about the thing that generated the money.)

http://www.brekiri.com/blog/ Greg4

It also means you can lose a lot of money without forcing legislators to deal with “widows and orphans” stories. Although it was interesting to see that even episodes like the Madoff story end up resulting in widows and orphans stories, so it's not a perfect defense.

To Chris's bigger point, the other thing that's missing in many of our current regulatory proposals is an understanding of why certain market mechanisms don't work. If we think accredited investors are at risk of being taken for a ride, let's figure out why and address those points (e.g., more disclosure, an exam, stronger fraud enforcement, whatever) rather than just saying “yeah, let's raise the income floor from $200k to $500k”). Those types of changes are arbitrary, more destructive of economic activity, and often more easily gamed. Any regulation will have some stifling effect, but in general I prefer to see some nuance instead of moving closer to “everything not prohibited is mandatory” type of regimes.

http://twitter.com/davekinkead Dave Kinkead

Chris,

I think invoking Adam Smith always requires caution. The positive claims of the invisible hand, that private vice leads to public virtue, are too oft used & abused to defend vice in laissez-faire style capitalism.

As Nash & game theory demonstrate, the invisible hand only works when private vice and public virtue are aligned. This alignment however, is purely coincidental. There is no market force that drives this alignment and left unchecked, private vice often destroys public virtue.

To ensure markets provide a public good, strong regulation is needed to align private and public incentive. So while it may seem to the outsider that Wall St and VC are the same, if the cost of increased regulation is the limitation of some VC activity, then that would be a small price to pay given the public costs of this last financial debacle.

Lets hope however, that legislators manage to regulate only where its needed – ensuring the alignment of private & public incentive – and avoid the unintended consequences that your link highlights.

http://www.brekiri.com/blog/ Greg4

Yes, but… I agree in principle that regulation is needed to address market failure. The problem is that regulatory failure is also not uncommon (e.g., regulatory capture). So we should be a bit skeptical before deciding that any new regulation proposed will actually do what's intended.
http://www.cdixon.org chris dixon

My point is partly that VC had nothing to do with the financial
crisis. I agree laissez-faire capitalism often fails- I just think on
VC it happens to work very well.

Riz 2

Regulation of VCs/investors could hurt the VC/investor biz…
I am a VC/investor…
…Therefore, this regulation could hurt me

The returns of the VC game point to it not working as well as you believe…

BTW, I agree this regulation is pointless and VC didn't have anything to do with the crisis, but let's not also point to VC-land as some sort of panacea of efficiency and all around awesomealiciousness.

Also, did VC land have anything to do with the 2000 meltdown?

http://www.victusspiritus.com/ Mark Essel

Like reusing code in the wrong locations we strive to classify and organize the nuances of the new with the withering frameworks of the past.

Startup investment is nothing like derivatives trading from my (admittedly amateur) perspective. While they both are “investments” in a broad sense. The path for each vehicle of cash, their liquidity, and the resulting market growth/healthy shrinking bear little resemblance. As I grow more informed, I'm less concerned with average returns, and much more interested in lasting consequences of those investments.

Does swapping the form of resources really create more social wealth?

I've become some type of rebellious social capitalist. The future will prove my hunches misguided or honest.

Riz 4

Dude – seriously, do you spend all day commenting on VC's blogs (Fred Wilson, Chris Dixon, Mark Suster, etc) and work on your entrepreneurial idea during blog commentary breaks?

Where do I send the check to invest?

http://www.victusspiritus.com/ Mark Essel

Hehe, I like to walk a few hours a day for exercise, and I can't really hack during that time. I'm just opinionated, and these blogs are a good place to air it out.

Where else would I want to hang during my free moments? I've met a great group of other founders bs'ing on solid blogs.

Riz T

You walk a few hours a day and write comments while walking? Very interesting…

In any case, props for a class response to my jab. Well played.

http://www.victusspiritus.com/ Mark Essel

I'm used to people harassing me for stuff they disagree with (I blog too, and pretty far out ideas). If you didn't believe it was important, you wouldn't have spent the time to write it.

http://avc.com fredwilson

we'll see how good Mark's product/service is when it launches. i can assure you i will pay attention when he launches it.

blogs are just another place to hang out. like the local coffee shop or the local pub.

you can make friends there and at the right time, those friendships can come in handy.

Riz T

Kudos to Fred Wilson for getting Mark's back. Returning the favor from Hacker News which is a cool thing to do. As Ali G would say “Ri-speck”

Coffee shop analogy is fine, but work and hanging out are two different activities (I'm sure there is some social media is blurring the lines gobbledy-gook folks can throw in here). I suppose I'll give Mark the benefit of the doubt and see what he comes up with. If all his blog comments prove to be useful in the pursuit of his biz, I'll be (1) forced to eat my words and (2) become a regular commenter on VC blogs myself.

(I remain skeptical)

http://www.victusspiritus.com/ Mark Essel

Contrary views are what makes ideas stronger. Bone headed ideas, without feedback remain crappy.

My blog comments both damn & propel pursuit of the biz I'm helping found (some aren't that well received, some get me props) -> my bet is they end up net positive. Regardless, they're my genuine perspective.

Not that I want to see you eat your words (I'm sure Chris may since you've been trolling him , but I'm going to do everything possible to build a business that creates real value for folks (the hard part is zeroing in, and constructing it – I'm still learning the ropes of web programming).

I'd love to see you attach your identity to your ideas. You gain little by being an anonymous poster in the peanut gallery. You might just make some friends that can help you out down the line. The part of the startup community I've communicated with is surprisingly interconnected and helpful.
http://avc.com fredwilson

You are right that mark is a voluminous commenter. But a few comments here and there are a good way to get a VC's attention – if that's what you want.

http://www.wac6.typepad.com William Carleton

Awesome perspective. Thanks for putting the current uproar in perspective, Chris.
http://how2startup.com/ Roy Rodenstein

Another way to look at it- there's little regulation preventing people from making microloans and contributing to microfinance organizations, or from making charitable donations generally speaking.

Perhaps angel investing should be viewed more from the lens of “a large micro-finance/mini-finance” investment. Then the question becomes how high do you let people go (e.g. $25k) with limited red tape, not how much red tape do you add to investing.
http://steamcatapult.com/ Dave Pinsen

“Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas”

Futures started out as a way to enable farmers and buyers of agricultural products to reduce their risks.

“From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.”

The problem here is that the term “Wall Street” encompasses a lot more than “Venture Capital” does. Wall Street includes initial public offerings, and secondary offerings, which are, essentially, the next links up on the food chain from V.C. investing, and serve a similar, useful, purpose, in raising capital for new and innovative businesses. Without that part of Wall Street, there would be a lot less venture capital being invested, since venture investors and founders would lose a main avenue for profitable exits.

Wall Street also includes mergers & acquisitions, which also facilitate exits for venture investors and founders.

In addition, Wall Street includes firms that raise money for cities and states with municipal bond offerings, the proceeds of which go to build roads, hospitals, etc.

I would venture (no pun intended) that the salient problems with Wall Street aren't the use of derivatives per se, but the excessive use of leverage in recent years, and the movement away from facilitating productive industry with public offerings, M&A, etc., to proprietary trading and profiting from rent seeking and regulatory capture.
http://fitnr.com Louis Marascio

Speculation is not a recent phenomenon. Speculators have always been in the market because they perform a valid and vital role in creating and maintaining market efficiency. Traders were speculating the futures pits from the beginning of the markets. Providing immediacy is a valid service (one of many) performed by official and un-official market makers–read, speculators. Why is this, all of a sudden, deemed evil? I just don't get it. Regulation of OTC derivatives markets is a good thing, and I'm all for it. But I just don't understand why there is such hate for the 'evil speculator'.

http://www.cdixon.org chris dixon

I didn't call it evil, but I do think (like you) it needs to be
regulated.

I wasn't trying to give an actual history- more just showing the
logical not historical progression.

http://fitnr.com Louis Marascio

To be clear, I think OTC derivatives need to be regulated. I don't think speculation needs to be. I understand, now, the intent but I think how and when you bring 'speculation' into the story here paints a picture that you think of speculation as the root cause of the problem.

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http://graphsofwrath.net/ wrathofgraph

Interesting statement “private vice really does lead to public virtue” how do we measure that? Great start up idea I am happy to speak with you about

I completely agree with looking closer. Judgments are too quickly made and minds to stubborn to reconsider.
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Chris Dixon

Capitalism just like Adam Smith pictured it