Sean Park Portrait
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I say profound things

High resolution economies.

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Bankers like to talk about channels – branches, call centers, internet, mobile. Sell the same products via multiple channels: adapt to individual customer preferences. Horses for courses. In wealthy developed economies, this way of thinking is mostly correct; or more precisely the resolution of the market renders the fallacies (of this way of thinking) invisible. To see the fundamental …

But please don’t forget the 1st law of financial dynamics…

Going to the Credit Ball?  (photo by George Kraychuck)Given my background as a senior investment banking professional in the credit markets, I feel somehow compelled to comment on the just proposed “market meltdown” fund (the Guardian’s moniker not mine.) On the plus side, even if substantively it achieves no more (than would otherwise be achieved by independent market forces) than increase confidence – thus improving liquidity – in these markets, that in and of itself is a good thing. (And analogous to a central bank’s ability to be a stabilizing influence in money markets…) And on this basis, as long as there is no explicit or implied taxpayer guarantee stealthily underwriting the effort – or coercion for that matter, the banks who are keen to finance this fund should obviously be allowed to get on with it.

(from the Guardian article) The US plan would see banks pooling mortgage securities and other illiquid assets in the hope it would prevent forced sales that could generate losses of billions of dollars and send shockwaves through the entire financial system.

Pooling the ailing assets into a separate warehouse may help to isolate the risk, restore confidence and even allow the fund to offload the assets at a better price than if banks individually rushed for the exits, it is believed.

At the risk of sounding patronizing, I would only suggest that the banks behind this fund don’t forget the law of conservation of risk: the underlying risks – the fundamental risk quarks – remain immutable. This does not diminish the potential value that can be created by rearranging and recombining this risk into different shapes and sizes, however the likelihood of this ultimately succeeding is in my opinion increased significantly if this ‘financial law’ is explicitly acknowledged by the financial professionals doing the engineering. Historically this has not always been the case (and has in my view been a key factor in creating some of the problems this fund now seeks to repair.) I imagine that Mr. Turner is thinking along these same lines:

(from the Guardian article) Some economists doubt, however, whether the plan will work. Graham Turner, of GFC Economics, said: “It is little more than a confidence trick that does not go to the heart of the matter – namely how to prevent the downward spiral in property prices and escalating foreclosures feeding off each other.”

I would also raise a second point which is to highlight the potential (inherent?) conflict of interest in such a fund as it would seem that it will be buying securities from its owners and is structurally engaged in a form of self-dealing. Assuming that the fund buys only securities that are misvalued by the market due to a situational (and temporary) structural imbalance of supply and demand (due to the rapid unwinding of substantial leverage in the asset class), this is probably a good thing (both for the markets and for the banks’ shareholders) however ultimately either overall leverage needs to decline (more equity injected into the asset class) and/or underlying fundamental losses need to be written off. This is true whether or not such a rescue fund exists.

Indeed the important medium term ‘$100 billion’ question is just how big are these real underlying losses and how much equity needs to be written off to clear the market. The banks in question are certainly in a good position to have a good understanding of what exactly this number is likely to be. If their management and motivation in setting up this fund is framed around accelerating the accurate repricing and acknowledgement of risk, than they can only be encouraged. If on the other hand, the real underlying driver is simply to reshuffle the deck and keep the dance going (not my metaphor!) then the credit prom might end up looking more like this:

On the road to the Singularity.

One step closer to the PSC (personal super computer)?

This past winter Calvin College professor Joel Adams and then Calvin senior Tim Brom built Microwulf, a portable supercomputer with 26.25 gigaflops peak performance, that cost less than $2,500 to construct, becoming the most cost-efficient supercomputer anywhere that Adams knows of. “It’s small enough to check on an airplane or fit next to a desk,” said Brom. Instead of a bunch of researchers having to share a single Beowulf cluster supercomputer, now each researcher can have their own.

But what I really want to know is how long I have to wait for a MacBook Pro with 100+ qubits?

The heart of any quantum computer, whether it’s built on a sliver of semiconductor or not, is the qubit. A word about the qubit: it’s odd.

In an ordinary computer, information is stored as bits, usually a minuscule reservoir of charge or the charge’s absence in a memory cell’s capacitor. At any given instant, an ordinary binary digit can be in one and only one of two different states. But the value of a qubit is determined by the quantum states of individual particles. So, like those quantum states, a qubit can have the value 1, or 0, or it can be—in the paradoxical world of the quantum—both values at the same time. This versatility is central to the power of quantum computers. In an ordinary computer you can represent a number between 0 and 31 using five binary digits. But using the same number of qubits you could represent all 32 numbers at once and perform the same calculation on them simultaneously. And that’s not even the end of the weirdness: two or more qubits can be linked together in ways no two transistors could ever be, influencing each other instantaneously—even if they are separated by a distance of light-years.

Now I just need to figure out what the equivalent of ‘quantum entanglement’ for finance…do risk quarks have spin???


IBM (via NY Times)

(from the NY Times) Researchers at I.B.M. laboratories say they have made progress toward storing information and computing at the level of individual atoms.

The scientists documented their work in two papers appearing on Friday in the journal Science. Both papers are focused on new understanding of the behavior of magnetism at the tiny scale of nanotechnology, where scientists hope to develop electronics made from components that are far smaller than today’s transistors and wires.

In one paper the researchers describe a technique for reading and writing digital ones and zeroes onto a handful of atoms, or even individual atoms. The second paper describes the ability to use a single molecule as a switch, replicating the behavior of today’s transistors.

The papers are the latest indication that computing technology is beginning to emerge that could replace today’s microelectronics materials in the next decade.

Florida bets annual state budget on 23 Red.

Well not exactly but pretty damn close: replace 23 red with frequency and intensity of storms hitting population centers in Florida and it is spot on. Only with 23 Red, at least the probability is easy to price.

Of course, ‘gambling’ is illegal in the Sunshine State
and if any resident wanted to offer or take odds on the likelyhood of a hurricane hitting their home town, of course they would be breaking the law. The irony of the state taking a giant punt with their taxpayer’s dollars is of course almost certainly lost on the state government…

One of the most significant business and economic opportunities that will arise out of the changing techno-economic paradigm over the coming ten to twenty years is the rethinking and transformation of the business of insurance. The rise and rise of the risk quark will inevitably reshape the landscape of risk transfer and mitigation. But it won’t be easy. Indeed their will be many backward steps along the way as the trinity of inertia, vested interests, and outdated regulatory frameworks conspire to perpetuate the current model despite it’s increasingly obvious failings.

How else to explain the recent de facto nationalization of property insurance in the State of Florida? (from The Economist:)

…insurance companies are shedding customers as fast as they can…

…The slack is being picked up by a fast-growing state-run company, Citizens Property Insurance. Citizens is acting as the insurer of last resort, underwritten by the Florida Hurrican Catastrophe Fund, a pool financed by the state. In January the state decided it could resolve the crisis by expanding Citizens and making it more competitive with private companies. It is now by far the state’s largest home-insurance provider, with 1.3m clients.

…And by allowing Citizens to grow so big, in the eyes of many agents, the state is exposing itself to tremendous financial risk in the event of a large-scale disaster. Unlike private companies, which can seek reinsurance on the global market where risk is less concentrated, the state would have to go to its own taxpayers if a huge storm struck.

Now whether or not the state should bear the risk of weather-related property damage is in my opinion a political debate. What I find appalling is not that a democratically elected government decides (or not) to underwrite this risk, but that they do so in a completely reckless, opaque and market-distorting way. By not allowing the market to work – by pricing risk appropriately based on the market-determined probabilities of certain outcomes – the result is that the economy cannot optimally allocate resources and that the true cost of any subsidy is at once much higher (than it would otherwise be) and completely opaque. Furthermore it is unaccounted for: I doubt that the Florida government accounts reflect the enormous contigent liability they have committed their citizens to.

Just as physicists and chemists have conservation of mass and energy, so to are risk quarks ‘conserved’. Risk transfer and optimization is highly useful and increases overall wealth and utility in an economic system. But risks – like mass and energy – must be conserved. Call it the 1st Law of Financial Dynamics. (Park’s Law? anyone? anyone? … 😉 ) One of the fundamental problems of the current risk management paradigm, is that it encourages – often with regulatory and governmental connivance – the dissimulation of ‘inconvenient’ high energy risk quarks.

What do I mean by ‘inconvenient’ risk quarks? These are the elements of risk in any system that when ‘removed’, allow all (or at least all incumbent) constituencies to have only positive outcomes. My contention is that risk is conserved so these elements are never truly removed, but only hidden from view. Worse, frequently the financial physics of segregating and obscuring these elements most often leads to an expensive and suboptimal distribution of risk throughout the system. Indeed -whilst I don’t know whether he would agree with any of my analysis – I believe that Warren Buffet’s view of (financial) derivatives as weapons of mass destruction, is credible only in the context of their (derivatives) bastardized deployment within a system that does not want or allow them to exist unfettered or transparently. The existing industry and governmental complex is applying the rules of classical finance to a new quantum world. With alarming consequences.

And don’t even get me started on sub-prime… (Remember always that gambling is illegal in the US. Well…only as long as it is done in a transparent and robust fashion. Embed it, hidden, within the existing fabric of business and of course it’s ok. Messy yes. But not threatening to the existing socio-institutional paradigm.)

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Making markets murky.

This recent article in the Guardian got me thinking about how much I don’t like markets where hardware is subsidized by long-term, locked-in service contracts. The most ubiquitous of these are those for mobile telephony, cable/satellite television and (to a lesser extent as the necessary hardware is cheaper…) broadband internet access. Now it looks to be coming to power markets with the introduction of ‘smart metering‘:

Householders switching power companies face having to sign broadband-style contracts from today after the energy regulator told the power companies they can now force customers to sign long-term agreements.

Ofgem yesterday said it was removing the rule that ties a customer to an energy supplier for just four weeks. Industry observers immediately expressed concern the move will allow the big six companies to impose year-long minimum contracts and financial penalties for getting out early – typical conditions that apply in the mobile phone and broadband markets.

Ofgem said it had removed the restriction to encourage the power firms to introduce energy efficiency measures and smart meters in their customers’ homes. So far, the power firms have been reluctant to install energy-efficient boilers or loft insulation because there was nothing to stop the customer switching to a rival after the work was carried out.

The scrapping of the 28-day rule will allow companies to make such improvements, Ofgem said. In return firms will be able to demand the customer signs a long-term supplier deal. “We see this as a very positive thing for consumers,” said an Ofgem spokesman. “We consulted widely on this issue and all the interested parties have agreed that its removal will stimulate future investment in energy efficiency measures.”

I understand why this kind of pricing policy is so seductive to most consumers – it is a variation of the classic installment plan and basically exploits the fact that the vast majority of people either don’t understand or fail to apply the principals of net present value in assessing the cost of the goods and services they purchase. (The same lack of financial literacy drives many to borrow long term on credit cards at close to 20+%, when even the weakest could probably borrow at unsecured rates of 10-12% through specialist non-prime providers.) It’s not a question of cash flow – although I suppose many would use this as an argument (in favour of subsidized hardware) along the lines of: “yes I know the long term costs will be higher but I just can’t afford £300 up front for a phone/cable box/smart meter/etc.” Well, yes that is certainly true but you would be better off borrowing the £300 to finance your capital investment, as the implicit financing costs built in to the ‘lock-in’ model are probably north of 30%(!) I think the problem is that most people don’t think of these purchases as capital investment, not that (they think) this type of purchase financing is the optimal structure. If it were or deemed so, we’d see cars given away by BP in exchange for a long term commitment to buy petrol (gasoline) from BP at above market rates. Or maybe they could team up with Norwich Union and offer a package…

I would like to see (especially in regulated markets where there is particular risks of collusion and/or significant barriers to new entrants – ie telecoms, energy, satellite tv, etc.) providers be required to offer unbundled packages and/or where relevant unlocked hardware. Let the customer decide. It may well be that consumer ignorance or apathy would mean that there would be few takers but at the very least it would drive further transparency into the embedded (and I suspect) usurious financing costs embedded in the bundled offerings. More importantly, it would allow a true decoupling of the pricing of distribution from the price of the underlying commodity, allowing the retail customer to manage these price risks separately and professionally, aided almost certainly by intelligent and automated agents.

Indeed, over the past year or so I have been educating myself as to the somewhat arcane issues involved in creating intelligent, real-time electricity markets (via the use of intelligent meters, real-time pricing and load management) as I see the modernization of this enormous risk market as a fascinating laboratory – for technology, business models and risk quarks – with the potential (along with financial services) to drive a paradigm shift from centralized, institutional, standardized risk management to distributed, individual and customized. (For those of you interested, I have found the Utilipoint briefings – which you can subscribe to online – very informative.) I’m pretty sure however this transformation will be somewhat long and painful as you have the all to familiar issues of turkeys-not-voting-for-Christmas coupled with various shades of regulatory capture and, at least for now, a relatively docile and uninterested population of consumers. Here is somewhere where ambitious regulators and legislators could really help in getting the ball rolling, something they don’t yet seem inclined to do.


If the Park Paradigm had a required (ok, recommended!) reading list – something that is on the “to-do” list (but don’t hold your breath) – the recent Economist Special Report on International Banking would be a recent addition. If you haven’t already, it’s definitely worth a read, especially for those of you that are from outside the financial services industry. Henry Tricks, the excellent Capital Markets Editor of the Economist, does a good job of framing and illuminating many of the key issues facing the industry today.

In a sidebar entitled Les fleurs du mal, the author highlights the emerging new risks and assets that are being traded and managed via markets, and comments on the increasing blurring of lines between banks and insurance companies in this context:

Now that technology and financial engineering have made it possible to isolate and trade all manner of risks, the insurance industry is marching ever more eagerly into the capital markets. Last year AXA, a French insurer, issued so-called mortality catastrophe bonds to protect itself in the event of large death tolls caused by, say, avian flu or terrorism. The bonds were put together by Swiss Re, a reinsurer, which had hired Jacques Aigrain, a former JPMorgan Chase investment banker, as its chief executive. It expects the market for insurance-backed bonds to leap from $25 billion now to at least $150 billion by 2015.

(I think this number will be much higher (than $150 billion) but is unlikely (only) to come in the form of a linear extension of today’s business, ie many new instruments and mechanisms for disaggregating, repackaging and distributing multi-faceted risks will emerge and contribute to this growth.)

The article goes on to speculate:

But the principle could be extended to all walks of life. Perhaps farmers will be able to buy weather products at their local bank as a hedge against a poor harvest.

Ahem…actually…farmers are already able to do that today (and do, as some of the early adopters and first customers) via Weatherbill. Indeed they have recently announced the addition of (quotes on) 170 new weather stations in the US improving even further the granularity of coverage on offer. (Here is my quick and dirty summary of Weatherbill.)

The article however finishes on a sceptic note, hightlighting the fact that the concept of

…”particle finance” in which every form of risk could be isolated and sold to the buyer with the biggest appetite for it…

Walrus and the Carpenter, John Tenniel

had been first developed by Charles Sanford (Chairman of Bankers Trust from 1987-1996) and that it hadn’t worked out too well for Bankers. Entertaining and clever writing perhaps, but the greed and ethical vacuum that eventually brought down Bankers was not the inevitable result of smart, forward thinking on risk (but rather imo the result of insufficient and poor middle management overwhelmed by a gold rush mentality.) Indeed the number of Bankers Trust alumni that have driven innovation and risen to senior positions across the financial firmament is a more apt illustration of the importance of these ideas. I was also curious to learn that Mr. Sanford had first developed the concept of particle finance, I had not encountered this metaphor before first using it myself a few years ago (and I have to admit it made me smile to see a Park Paradigm post at the top of the “particle finance” Google search, just ahead of Mr. Sanford’s 1993 article ‘Financial Markets in 2020’, reprinted in the Federal Reserve Bank of Kansas City Economic Review!) but it is nice to see that this way of looking at the (inevitable) evolution of risk management has other significant champions. The vision he articulated in 1994 (when I was just a young whippersnapper of a bond trader, flinging around the front end of the French yield curve) is remarkably clear and insightful, and all the more so for having been written before the financial/technological boom of the late 1990s. I only wish I had first read it in 1993! And if any readers out there know Mr. Sanford, please let him know that I’d love to buy him a coffee and find out what he thinks now that we are halfway to 2020…and talk of risk quarks,

Of shoes—and ships—and sealing-wax—
Of cabbages—and kings—
And why the sea is boiling hot—
And whether pigs have wings.”

Financial derivatives are a good thing. Discuss.

Much has been written about credit derivatives in the mainstream financial press, most often with a take on whether they are “…a clever way to disperse risk, making the financial system safer…? Or are they “financial weapons of mass destruction”…poorly understood and perilous boosters of credit?” (taken from a recent article in the Economist but I could have selected any of dozens and found the same line of questioning.)

As someone who used to run a credit trading business at a large investment bank, I obviously have a view on the micro and macro issues surrounding credit derivatives, and perhaps the fact that I am no longer in such a position (and so no longer have a direct vested interest) will actually will give sceptics pause before dismissing my unreserved belief that they are – like any financial derivatives allowing better and more granular risk management (see my earlier thoughts on particle finance and risk quarks) – a welcome and useful addition to the financial ecosystem. And given the importance of credit risk in the risk firmament (in terms of explicit and implicit exposures embedded in the economy) it is no surprise that the market is growing exponentially in size and sophistication.

Rather than go into a long essay developing my views on the subject, which I suspect regular readers to be able to guess at in any event, I will refer you to an article I wrote three years ago (published in Euroweek in June 2004), entitled a “Brand New Line of Credit” if you are so inclined. Alternatively, the Economist briefing I allude to above does a pretty good job of articulating the issues to a non-specialist audience without dumbing it down to the irrelevant. (As an aside I wonder if the Economist would be willing to pay me for all the clicks and recommendations I send their way…the least they could do is refund me my subscription price! 😉 )

However, in reading this briefing, there is one line of reasoning (again often repeated) that is a classic example of how context often colours thinking on (the suitability/riskiness/acceptance of) financial products, leading to different conclusions for what are fundamentally equivalent or entirely analogous things. (See this post on the sameness of betting/options/insurance as background on this line of thinking.) In particular, I am puzzled as to why insurance of default or repayment risks is questioned any more than any other insurance market.

(from the Economist briefing)

…However credit derivatives create a moral hazard…

…So the system may seem to have become safer, but new dangers could be in the making. Perhaps credit derivatives will alter the behavior of investors and companies, encouraging them to take more risk. That seems to have happened in the American sub-prime mortgage market, where underwriting standards fell sharply in recent years, leading to a rapid rise in delinquent loans. Perhaps corporate borrowers will default more than derivative investors imagine, or perhaps investors will recover less value when they do default.

In other words, if individuals feel safer they may act less responsibly. This is the “seatbelt problem”: motorists wearing belts may drive faster knowing they are less likely to go through the windscreen if they have an accident. The overall level of risk ends up the same.

Oh boy…there are so many holes and fallacies in this line of thinking, I don’t know where to start. Firstly, the whole point of risk management tools is to allow and even encourage economic actors to “alter their behavior” – to optimize their risk based on their appetite/mandate/purpose/skills/capital/etc.; “take more risk” in this generic negative connotation is absolutely devoid of any meaning. But it sounds scary (think Count Floyd)! As for the sub-prime mortgage market, my quick and dirty thoughts are here, but suffice to say that it has been an unmitigated success in extending the access to capital and lowering its costs for a significant and previously under-served part of the economy. Were there poor practices? Uninformed customers? Certainly I’m sure. But people have car accidents to – sometime due to faulty products, sometimes due to ignorance, sometimes due to their own stupidity, and sometimes to miscalculating a deliberately taken risk. Society has developed pretty effective means for seeking to minimize, mitigate and learn from all these possible negative outcomes without calling into question the usefulness and enormous benefits provided by the automobile.

As for the “seatbelt problem” or moral hazard, I’m not sure I can add much to the thousands of papers, articles and books that have tackled this subject , but I will take issue with the implication that “the overall level of risk ends up the same” is a poor outcome. Again the “overall level of risk” is firstly largely devoid of meaning – context is important – and even assuming that the author is implying some relevant closed system to give this notion context, the distribution of risk within that system is more important (in determining the probability of good or bad outcomes for the system) than it’s absolute level. Half the problem probably arises out of the semantics of the word ‘risk’ which is understood by most people as monolithically something to be avoided rather than something to be managed (avoid/hedge the risks that are irrelevant or dangerous to you and embrace those where your talents, experience and expertise allow you to benefit from them.)

Gilbert Huph

Coming back to my question – why is insurance of default or repayment risks questioned any more than any other insurance market? For me it is obvious: if you think that insurance is a useful financial tool in an economy, I don’t know why you would discriminate against one type versus another; indeed the issues thrown up by moral hazard would seem to be much more serious in many other (unquestioned) insurance markets, probably because they have been intelligently addressed. My suspicion however is that much of the fear of credit derivatives comes from a combination of nomenclature, lack of understanding and faulty reasoning. I touched on the latter above, and the first two are probably inter-related – the semantic distinction between derivatives and insurance (which is just a product subset of the former) is unfortunately embedded in the public’s mind however irrational it may be. Of course Wall Street and City investment banks and bankers do nothing to dispell this myth (except perhaps in extremis when the regulatory and political pitchforks are well and truly bearing down on them) because, well…what would you rather be: a Derivatives-Trader-Master-of-the-Universe? or some insurance guy? Hey Tom Wolfe never wrote anything about any risk manager at an insurance company… Besides it’s easier to charge a lot for something that sounds complicated.

So…as long as I can insure against the risks of my factory being destroyed by a tornado, I don’t see why anyone would question my desire or ability to insure against the insurance provider being able to pay out when the tornado hits…

(…but I wouldn’t be surprised to see a symposium on credit derivatives shown on Monster Chiller Horror Theater, it would be right up Count Floyd’s alley:)