Transcription
Money. It's the stuff that makes the modern world go round. But have you ever stopped to think about how it all actually works? How the money you earned at your job sits in your bank account and then gets loaned out to businesses to build skyscrapers that then get used to hire more people making even more money. And then that money doesn't just go to commercial banks. It goes to businesses, the government, insurance companies, investment banks, pension funds, mutual funds, hedge funds if you're rich, and maybe even some private equity or venture capital funds.
Welcome to the financial system. An entire world of interconnected organizations that creates, moves, and multiplies money all over the world in ways you probably don't understand. In this video, we'll be looking at what these major institutions are, what they do, and how they work together to keep the global economy functioning smoothly and sometimes not so smoothly. By the end, you should have a broad understanding of the entire world of finance and what the biggest institutions in the world actually do. Let's jump in.
This is where money first gets created. Central banks are the government's arm within the finance system and they're part of the team that sets the rules and enforces them. Almost all countries have their own central bank. The US has the Federal Reserve, the UK has the Bank of England, and China has the People's Bank of China. Central banks do a bunch of things, but you can think of them as essentially playing God with the economy. And they do so using monetary policy, which is controlling the amount of money in the economy and controlling the interest rates. And they use these tools to try and achieve a couple of main objectives: price stability, so managing inflation, full employment, and overall economic prosperity for the nation.
Here's how it works. Let's say the economy is moving too slowly. A central bank will use expansionary monetary policies to essentially flood the economy with money. They do this by cutting interest rates and pumping cash into the system, either by printing it or through open market operations like quantitative easing. This means borrowing money becomes super cheap. So businesses take out more loans to expand. People take out more mortgages. And so overall in the economy, there's now more productivity. This increased productivity requires more workers and higher wages. And more money in people's pockets means more spending, ultimately creating a cycle that results in a booming economy. It's why you'll hear presidents like Trump pressuring the Fed Reserve chairman to cut rates and stimulate the economy. A booming economy makes him look good.
But there's a catch. All this extra money and demand in the economy will cause prices to skyrocket. And so when inflation starts to get out of hand, central banks will use contractionary monetary policies to slam the brakes. They jack up interest rates and suck money out of the economy using quantitative tightening. Quantitative easing and quantitative tightening are specific types of open market operations. And it's when a central bank will either buy or sell government bonds. So if a central bank sells a bunch of bonds, they're essentially taking money out of the economy and parking it at the central bank. And this chills inflation. This is known as quantitative tightening. And they'll do the opposite in order to stimulate the economy. They'll buy a bunch of bonds, giving back to the institutions in the economy, which is quantitative easing. So, central banks are basically the puppet masters controlling what way the economy goes and how much money is in circulation. It's why so many people care about interest rates.
Time to move on to commercial banks, though. If central banks are the puppet masters, then commercial banks are the workhorses of the financial system. We're talking about places like JP Morgan, Wells Fargo, Bank of America, or whatever big four bank you use in your country. Commercial banks are where most people's money lives. Your paycheck lands there. You pay your bills from there. And you might even take out a mortgage or car loan through them. But their real role is moving money from savers to borrowers. Think about it like this. On one side, you've got surplus units, people with a surplus of money. Everyday people with cash sitting in their accounts, retirees with pension payments, or companies with excess profits as examples. On the other side, we've got deficit units, startups that need capital, home buyers looking for mortgages, and businesses trying to expand. Banks sit in the middle. They pull together all that idle money from savers and they lend it out to people and companies that can put it to work. This keeps money constantly flowing through the economy instead of just sitting around being unproductive.
There's a pretty big twist here, though. Banks don't just lend out the exact deposits they receive. When they issue a new loan, they actually create new money. In other words, they're lending you money they don't actually have. Traditionally, this was explained with something called a reserve rate. Say it was 10%. If a bank had $10 million in reserves, it could lend out $100 million worth of loans. Guess what the reserve rate for most major economies is these days? 0%. Now, this doesn't actually mean that they can just loan out an infinite amount of money. There's things like capital requirements and liquidity rules and credit checks and whatever else that determine how much they can lend. But this ability to transform savings into loans and in the process expand the money supply is what makes commercial banks the beating heart of the modern financial system.
Now, even though we said earlier that your paycheck lands in commercial banks, there's a place that takes around a 10% cut of that paycheck before it ever hits your account, and that's a pension fund. Pension funds are hedge funds run by pensioners. Kidding. They're actually the biggest financial institutions on the planet and control over $60 trillion worldwide. That's almost Lizo's weekly food budget. Pension funds are giant investment pools designed to make sure people still get paid after they stop working. So, they're essentially the system that keeps retirees from going broke. The thing with pension funds, though, they don't just stick that money into a savings account and earn 2%. That's pathetic. Instead, they aim for around 6 to 7% a year, and they do so by diversifying across almost everything. Stocks, government bonds, corporate bonds, real estate, not just any real estate, since they manage so much money. We're not talking a couple of houses here and there. We're talking landmarks. For instance, the Ontario Municipal Employees Retirement System owns huge assets like Hudson Yards and the Olympic Tower in New York and the B Springs Hotel in Canada. And they don't stop there. They pour money into hedge funds, venture capital, and private equity funds. In fact, they're the largest single source of capital for PE and VC firms. And that's part of what makes them so important. When a private equity firm raises a new multi-billion dollar fund, chances are a pension fund is writing one of the biggest checks. So, while pensions might feel invisible and irrelevant while you're young, they're quietly one of the most powerful players in global finance.
Which brings us to another extremely powerful player, Mutual Fund. Before we go any further, I want to quickly tell you about Chat LLM from Abacus AI, the sponsor of today's video. I've recently been using their awesome tool, Chat LLM, to help me with my workflow. The main reason I like it so much is because it has all the most powerful large language models in the same place. I used to have multiple chat GPT tabs, a Grock tab, sometimes even a midjourney tab. Now I have all of that in Chat LLM. And so as you can see here, I'll put in a prompt like "how many Bitcoin did Ross Ulbricht lose when the Silk Road went down?" and Root LLM will direct the query to the LLM it thinks will do the best job. In this case, ChatGPT 5. And if I don't like the answer, I can then ask it to regenerate using Claude Sonnet or any other model, really. The craziest thing is that it's only $10 a month. Grock is like $30 a month. Chat GPT is $25. Claude is another $30. I now literally get access to all of them for $10. Oh, and don't forget about the $50 that MidJourney costs. Yes, Chat LLM handles image and video generation like a pro. Guys, this one will honestly save you money and make your workflow so much easier. Go visit chatlm.abacus.ai. Click the link in the description to check them out. A big thanks to the Abacus team for sponsoring the channel. Now, let's get back to the video.
Mutual funds are basically investment clubs for regular folks. Instead of needing millions to play in the markets like a hedge fund, which is our next section, anyone can throw a few thousand bucks into a mutual fund and get professional management. These are guys like Vanguard, Fidelity, BlackRock, etc. Here's how they work. They take money from thousands of everyday investors, pull it together, and then buy giant baskets of assets: stocks, bonds, real estate, whatever the strategy calls for. So, it's like a pension fund, but you can pull your money out at any time. It's not just for retirement. When you put money in a mutual fund, you buy shares of the mutual fund, which makes you a part owner of everything they own. So, if you invest $5,000 into a $100 million fund, you own 0.005% of it. If the fund goes up 5%, you just made $250 bucks before fees. The biggest selling point for mutual funds is the diversification. Imagine manually trying to diversify $5,000 across 500 different stocks or other assets. Tedious and stupid. And so mutual funds give ordinary investors access to a much wider spread. And they generally come in two flavors: actively managed funds or passively managed funds. The active ones hire professional managers who spend their days researching stocks, calling CEOs, and crunching spreadsheets. And these guys are trying to beat the market. Passively managed funds don't bother trying to outsmart the market. They just copy an index like the S&P 500 and call it a day. Since passive mutual funds don't need to hire any finance bros to stockpick, their fees are much, much cheaper.
But mutual funds are for peasants. The big dogs park their money in hedge funds. Hedge funds like Bridgewater, Jane Street, and Citadel are the money-making playgrounds of the ultra-rich. Unlike mutual funds that anyone can jump into, hedge funds are only open to accredited investors. In the US, that means you've got at least a million dollar net worth, not including your house, or you're making $200k a year. Why? Because hedge funds can be insanely risky. Here's how they work. They raise a bunch of cash from pension funds and wealthy individuals and then use it to place some of the boldest bets in finance. The funny thing is, most hedge funds actually underperform the S&P 500. Idiots. But the rare ones that hit it big, they absolutely crush it. Jim Simon's average annual returns triple Warren Buffett's average annual returns. But this market magic obviously comes at a cost. Most hedge funds charge 2 and 20: a 2% management fee of all the money they manage and 20% of the profits that they make you. And unlike mutual funds which just buy assets and hope they go up, hedge funds bet on literally anything. Stocks going up, stocks going down, currencies crashing, interest rates moving, oil prices, crypto, even who's going to win an election. And they get to do so with far fewer regulations, which is what makes them risky for peasants. They get to short sell or bet against companies. They use huge leverage, which is borrowing a bunch of money to supercharge their trades. They use complex derivatives like options, futures, and swaps. And these days, they're using a hell of a lot more AI to run their trades. The added risk and infinite greed will often also result in prison time for our boys managing billions.
But now, let's move on to the institutions that keep the Colombian, Peruvian, and Venezuelan economies afloat. Investment banks. Investment banks like Goldman Sachs, Morgan Stanley, and Citigroup are basically the corporate matchmakers of Wall Street. They connect big businesses, governments, and institutions with money. A lot of money. Investment banks technically do a whole bunch of things: trading, lending to hedge funds, selling bonds, but their bread and butter comes down to these three big ones: taking companies public, mergers and acquisitions, and raising capital. Let's start with IPOs. When a private company wants to go public, they call an investment bank. The bankers figure out how much the company's worth, crank through mountains of paperwork, and most importantly, hype it up to investors so the stock actually sells. Like in 2012 when Morgan Stanley took Facebook public and raised $16 billion in a single day. That's the GDP of a small country hitting your bank account overnight.
Then we've got mergers and acquisitions. When one company wants to buy another, things get messy fast. You've got to value the target, negotiate terms, and comb through years of financials to make sure you're not buying a dumpster fire in disguise. It's the equivalent of making sure the pretty tie girl you're going home with isn't actually a lady boy. That's why companies will hire investment banks with armies of analysts and lawyers to run the numbers and keep billion-dollar deals from collapsing.
Third, we've got raising money. When companies need more cash than they can get from a normal bank loan, that's when the Patagonia vests step in. They help issue corporate bonds, arrange massive loans, or sell more shares. And the key skill they offer in this regard is simply convincing investors to hand over their cash. And these guys are really good at it. So good, in fact, they even sell scams. Like when Goldman helped Malaysia's 1MDB fund raise $6.5 billion through bond deals, money that ended up being siphoned off into this guy's personal bank account. So yeah, investment bankers are the ones who actually make billion-dollar deals happen.
One of the institutions they help cut billion-dollar deals is private equity. Private equity firms are basically house flippers, but for companies. They raise mountains of money and just as much debt from pension funds, commercial banks, and whoever else. They buy businesses, fix them up, and then flip them for massive profits. And it's a pretty killer business model considering there's firms like Blackstone, Apollo, and KKR who each manage hundreds of billions of dollars. Blackstone's even crossed the $1 trillion mark. Here's how it works. A group of rich guys launch a private equity fund. They use their names and track records to raise billions from pension funds, insurance companies, and other wealthy investors, promising them juicy returns. And once the money comes in, they go hunting for companies to buy. But here's the sneaky private equity play. They use leverage and pretty much as much leverage as possible. Say they're buying a $100 million company. They'll put down $20 mil and borrow $80. Then what they do? They dump the $80 million in debt onto the company's books. They technically own the company, right? So of course they can do that. So now if the company goes south, the private equity firm doesn't owe [ __ ] This is known as a leveraged buyout or LBO and it's classic private equity.
Anyways, after the takeover, the fix-up begins. Sometimes it's a real fix-up. Other times it's more of a spring clean and fire sale. They'll replace management/jobs and shut down entire departments like R&D if it's not making money now. The goal isn't usually long-term health. It's short-term profits. And if it works, they flip the company in a few years for 3 to 5x what they paid. Like when Blackstone bought Hilton Hotels in 2007 for $26 billion, only putting in $5.6 billion of their own money, and walked away with $14 billion in pure profit 11 years later. And what about when things go sideways? Private equity still finds a way to win. They strip and sell assets to recoup their investment, which is usually only around 20% of the company value. So, a super easy hurdle to achieve. And then they leave the company drowning in debt and interest payments. Like Toys R Us, which was loaded with $5 billion of debt by KKR, Bain, and Vornado. The company had to pay over $400 million in interest every year until it finally filed for bankruptcy in 2017. And when that happens, the pay guys just shrug, collect their fees, and move on to the next deal.
You know what other companies these guys buy? Insurance companies. Insurance companies are basically the world's professional risk spreaders. No, no. Risk spreaders. Risk spreaders. Anyways, companies like State Farm, Allstate, and Geico take in premiums from a huge pool of people and in return promise to pay if something bad happens. Car crash, house fire, medical bills, you name it. The trick is that the chances of everyone getting hit with a disaster at the same time are tiny. So, insurance companies redistribute the burden. The healthy customers subsidize the sick. The safe drivers subsidize the crash victims. The lucky homeowners subsidize the unlucky ones. It's risk diversified across millions. And we buy insurance for everything: health, property, life, even our pets. Most of the time, nothing happens. But the companies are still collecting premiums every single month, often for decades. And this leaves insurers sitting on stacks of cash. And so instead of just letting the cash gather dust waiting for claims, they invest it heavily. They pump money into bonds, which is usually their favorite because it's steady and predictable, but also stocks, real estate, and even private equity or VC funds. So, while you're paying that little monthly premium, your money isn't just sitting there waiting for something bad to happen. It's being quietly recycled into global markets, making insurance companies some of the biggest investors on the planet.
Venture capitalists, also known as VCs, are basically gamblers who throw tons of money at startups, hoping that one hits the jackpot. It's no wonder the most famous VC podcast in the world is named "All In." But anyways, here's how it works. A VC firm like Sequoia Capital or Andreessen Horowitz will walk up to pension funds, university endowments, sovereign wealth funds, and insurance companies asking for millions, if not billions of dollars. They pitch some rubbish about their ability to spot diamonds in the rough. And everyone in the room pretty much knows it's [ __ ]. But the investors don't really care. If you've already got billions sitting in safe bonds, tossing a few million into high-risk startups is worth it. Because even if just one of them blows up into the next Facebook, the payoff covers all the losers. This is known as the power law. Let's say you've invested in 100 different startups. Odds are around 90 will fail. Maybe seven will return the same money you put in, and two to three will make you money. But those two to three will make you maybe even more than 10,000 times the money you put into them, thereby covering all the losses of the other 90 and making a profit on the overall portfolio. Take Peter Thiel's Founder Fund, for example. Back in 2004, they tossed $500k into a random social network called Facebook. It was just one of hundreds of bets they made that year, most of which went nowhere. But Facebook turned that little $500k check into over a billion by the time they went public in 2012, more than a 2,000x return. That's the VC model in a nutshell: make tons of bets, lose the majority of them, but have so much money on the handful of winners that it really doesn't matter.
So to wrap this up, the financial system is like a giant machine with all these different institutions acting as the gears. Central banks control interest rates and the money supply. Commercial banks keep money flowing from savers to borrowers. Pension funds make sure you're not broke when you're old while quietly bankrolling private equity and venture capital. Mutual funds let everyday investors diversify without needing millions. Hedge funds gamble with billions on anything they can bet on. Private equity flips entire companies like their houses. Venture capitalists spray money at startups praying one hits the jackpot. Investment banks make million-dollar deals actually happen. And insurance companies spread risk while doubling as massive investors. Together, they don't just move money. They create it, multiply it, and sometimes even destroy it. And whether you realize it or not, every paycheck you earn, every loan you take, every premium you pay is fueling this invisible web that keeps the global economy alive. Thanks for watching, and I hope you enjoyed the video. Please remember to like, comment, and subscribe.