The micro-cracks are turning into fissures, soon to be gaping crevasses as (finally) the obsolescence of our industrial age banking system plays itself out in spectacular front page headlines. Meanwhile it would seem that our society and our leaders are (mostly) frozen in some kind of macabre trance – eating popcorn and mesmerized by the inevitable Crash.
If you look at the LIBOR scandal in the context of the technology of the fast emerging information economy, it is absolutely mind-boggling that such an anachronistic process even exists in the world of 2012. In a world where every financial flow is digitized and only really exists as an entry in a database. In a world where truly enormous real-time data sets (ones that make the underlying data required for a true LIBOR look puny) are routinely captured and analyzed in the time it takes to read this sentence. In a world where millions (soon billions) of people have enough processing power in their pocket to compute complex algorithms. In a world where a high school hacker can store terabytes of data in the cloud. Â In this world, we continue to produce one of the most important inputs into global financial markets using the equivalent of a notebook and a biroâ€¦ WTF???
The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.
For each (of 10) currencies, a panel of 7-18 contributing banks is asked to submit their opinion (yes, you read right) each morning on what each rate (by maturity) should be. The published rated is then the “trimmed arithmetic mean”; basically they throw out the highest and lowest submissions and average the rest. No account is taken of the size or creditworthiness or funding position of each bank and the sample size after the “trimming” for each calculation is between 4-10 banks. However, the BBA assures us that this calculation method means that:
…it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.
You don’t need to be a banker or a quantitative or statistical genius, or an expert in sociology, or even particularly clever to figure out that this is a pretty sub-optimal way to calculate any sort of index, let alone one that has an impact on the pricing and outcomes of trillions of dollars worth of contractsâ€¦
In the 1980s when LIBOR was invented – and (lest the angry mob now try to throw the baby out) it should be said an important and good invention – this methodology just might have been acceptable then, as the “best practical solution available given the market and technological context.” Banks used to have to physically run their bids in Gilt auctions to the Bank of England (thus why historicallyÂ banks were located in the City, tough to compete on that basis from the West End or Canary Wharf, at least without employees a few Kenyan middle distance Olympiansâ€¦) But you know what? Â And this is shocking I know…Â They don’t do it that way anymore!!!
So if LIBOR is important (and it is), how should we be calculating this in the 21st century? Here’s a few ideas:
include all banks participating in the market – and not necessarily just those in London – how about G(lobal)IBOR??
collect and maintain (in quasi-real time) important meta-data for each contributing bank (balance sheet size and currency breakdown of same by both deposits and loans, credit rating, historical interbank lending positions, volatility/consistency of submissions, derivative exposure to LIBOR rates, etc.)
collect rates and volumes for all realized interbank trades and live (executable) bids and offers (from say 9-11am GMT each day)
build robust, complex (but completely transparent and auditable) algorithms for computing a sensible LIBOR fixing arising from this data; consider open-sourcing this using the Linux model (you might even get core LIBOR and then forks that consenting counterparties might choose to use for their transactions, which is ok as long as the calculation inputs and algorithms are totally transparent and subject to audit upon request1)
This is not only possible, but in fact relatively trivial today. Indeed companies like the Climate Corporation*, Zoopla*, Metamarkets*, Palantir, Splunk (and dozens and dozens more, including newcomers like Indix* and Premise Data Corp) regularly digest, analyze and publish analogous datasets that are at least (almost certainly far more) as big and complex as the newLIBOR I’m suggesting.
Indeed, the management of this process could easily be outsourced to one – or better many – big data companies, with a central regulatory authority playing the role of guardian of standards (the heavy lifting of which could actually be outsourced to other smart data processing auditorsâ€¦) In theory this “standards guardian” could continue to be the BBA(the “voice of banking and financial services”) but the political and practical reality is that it should almost certainly be replaced in this role, perhaps by the Bank of England, but given the global importance of this benchmark, I think it is also worth thinking creatively about what institution could best play this role. Perhaps the BIS? Or ISO? Or a new agency along the lines of ICANN or the ITU -Â call it the International Financial Benchmarks Standards Insitute (IFBSI)? The role of this entity would be to set the standards for data collection, storage and computation and vet and safekeep the calculation models and the minimum standards (including power to subsequently audit at any time) required to be a calculation agent (kitemark.) Under this model, you could have multiple organizations – both private and public – publishing the calculation and in principle if done correctly they should all get the same answer (same data in + same model = same benchmark rate.) Pretty basic “many eyes” principal to improve robustness, quickly identify corrupt data or models.
As my friend (and co-founder of Metamarkets and now Premise Data Corporation) David Soloff points out:
If nothing else, this weekâ€™s revelations show why it is right for British political figures, such as Alistair Darling, to call for a radical overhaul of the Libor system. They also show why British policy makers, and others, should not stop there. For the tale of Libor is not some rarity; on the contrary, there are plenty of other parts of the debt and derivatives world that remain opaque and clubby, and continue to breach those basic Smith principles â€“ even as bank chief executives present themselves as champions of free markets. It is perhaps one of the great ironies and hypocrisies of our age; and a source of popular disgust that chief executives would now ignore at their peril.
Rather than join the wailing crowd of doomsayers, I remain optimistic. The solution to this – and other similar issues in global finance – either exist or are emerging at a tremendous pace. I know this because this is what we do here at Anthemis. But I’m clear-headed enough to know that we only have a tiny voice. Clearly it would seem that our long predicted Financial Reformation is starting to climb up the J-curve. I just hope that if Mr. Cameron does launch some sort of parliamentary commission that voices that understand both finance and technology are heard and listened to. Excellent, robust, technology-enabled solutions are entirely within our means, I’m just not confident that the existing players have the willingness to bring these new ideas to the table.
* Disclosure: I have an equity interest, either directly or indirectly in these companies.
1There may exist some good reasons for keeping some of the underlying data anonymous, but I think it would be perfectly possible to find a good solution whereby the data was made available to all for calculation purposes but the actual contributor names and associated price, volume and metadata were kept anonymous and only known to the central systemic guardian. Of course you’d have to do more than just replace the bank name by some static code, it would need to be dynamically changing, different keys for different calculation agents etc. but all very doable I’m sure. You’d be amazed what smart kids can do with computers these days.
According to the June 22 letter, the review identified â€œvaluation concernsâ€ where â€œappraisal documentation is missing or incomplete,â€ or where property-assessment methods were â€œinsufficient/lacking.â€
Other missing information included employment confirmations, phone numbers, credit reports and rent verification, the letter said. The review also found â€œincome calculation errors.â€
Another fine example of six sigma in banking. Imagine if Dow and Dupont ran their chemical plants like this. Holy crap. Or Boeing built planes this way. Yikes. But then again, in those industries lives are at stake. Banking. [shrug] Just money. Ok a few billion hundred billion. But still, it’s not like anyone died. Sheesh.
Hmmm. In 2002 – yes 2002, seven years ago(!) – I wrote:
In a recent speech, Jack Welch, the former chairman of General Electric, made exactly this point: â€œ…[if] you put six sigma in an investment bank, they would all gag!â€ In case you think he was just engaging in some gratuitous banker bashing, consider this: six sigma quality means havingfewer than 3.4 defects or errors per million operations in a service process. That is 99.99966% perfection.
Contrast this benchmark with the assurance once made to me â€” by a senior syndicate manager of one of the largest and most respected global bond underwriters â€” that it was perfectly normal and necessary to expect and reserve for 5%-10% errors in the allocation of a jumbo multi-tranche bond deal! Assuming an average of 200 individual orders (including splits) on a typical new issue, to reach six sigma quality levels you would need to have fewer than four errors over 5000 issues!
…And therein lies the next major opportunity for capital markets bankers over the next decade: to use technology not only as an enabler of innovation (as has been the case over the past 15 years) but as a driver of industrial efficiencies.
The guys in IT thought it was an interesting take on things (with $ signs in their eyes) but the ‘business’ side, well, let’s just say it didn’t strike a chord. Banks were special. Bankers were (even more) special. All that re-engineering and total quality management and painful restructuring and shifting centres of power…all good for manufacturing and you know, “other” industries. The ones they advised and financed and funded LBOs of… but not banking. Banking is “different.” You wouldn’t understand…What. A load. Of. Crap.
Well now they are paying for it. We all are paying for it. Rivers didn’t catch on fire but the financial system was well and truly polluted. But there is a bright side. The bright side is that there has never been a better time to come in and build businesses in banking and financial services that have an engineering DNA, businesses that are natively adapted to an industrialized and digital way of doing business. Indeed some of the pioneers in this mold have already enjoyed tremendous success (Markit Group comes to mind.) Others are emerging. And the incumbents have never looked less frightening (even if, especially because, they are now too big to fail.)
In the spring of 2005 I wrote the “screenplay” for AmazonBay and we launched DrKW Revolution on July 1 2005 – I still have the t-shirt to prove it. So I must admit I had to laugh when my old colleague Stu pointed me to the Morgan Stanley Matrix I nearly fell off my chair laughing: it was deja vu all over again…
Don’t get me wrong, it looks pretty useful and I completely endorse the vision. In fact I sort of have to given that it is exactly in line with the vision we had for Digital Markets at DrKW over 5 years ago! (Although not quite as comprehensive as far as I can tell…) But what I love most is that in terms of look and feel – the hexagons, the music, the video (but I can re-assure you I didn’t wear a tie or speak from a teleprompter!) – it is Son of Revolution. Amazing. Actually feel quite proud that we at least left an impact, even if it didn’t happen to be at Dresdner Kleinwort.
I just spent a few minutes digging around on the wayback machine but unfortunately couldn’t find any good links. Really too bad because the Flash intro page was very cool and would have loved to be able to look at it side-by-side with MS Matrix. (Any current Dresdner folks would be great if you could dig this code out of the archives if it still exists!) Fortunately, I did have an old marketing card brochure hanging around:
I’d be lying if I didn’t admit that I can’t help but feel a little proud seeing some of my vision start to come to life, especially at such a blue chip conservative firm like Morgan Stanley, but I would also be lying if I said I didn’t feel like screaming ‘I told you so’ to all the senior executives at DrKW who refused to stick their necks out and support what I was trying to do. Let’s just say I’m not surprised at how it all ultimately turned out there. Karma. The good thing is that this bad feeling is way more than offset by remembering all the truly exceptional people I got to work with while I was at DrKW and the support I received from so many of them especially since it wasn’t necessarily politically correct to do so. It meant and still means a lot to me. Anyhow, it would be cool if Hishaam Mufti-Bey, the guy behind MS Matrix would add us as a little historical footnote on his About Us page, as I imagine it won’t be long until all the old DrKW links have disappeared; it’s important to remember!
Just one final point though. What the hell is it with traders and black Bloomberg-looking web design??? Every bloody website I see focused on institutional capital markets customers seems to use this look. Get over it! It was fantastic for Mike (and rooted in a real engineering problem by the way) but when other people copy them, well… it just makes you all look dumb. Hire a designer. Do something original. Your content and you customers deserve it. 😉
â€œThe future is already here – it is just unevenly distributed.â€
– William Gibson, Author
Update: Thanks to Martina for finding a slide version of the website stills / product look and feel…as you can see MS Matrix looks even more like DrKW Revolution than I remembered!
In May 2007 I wrote a post entitled “A requiem for last.fm?” in which I expressed my anxiety (as a very happy customer of last.fm) at CBS‘s ability to f*ck things up:
As a customer, I just hope that in the medium term they are allowed to continue to innovate and especially that they are able to continue to treat their customers with respect. As partners. That may seem self-evident, but the track record of the music industry in this regard does not inspire much confidence. Indeed it is testimony to the compelling and real value of creative artists and their product, that the industry continues to function at all. If music truly was a â€˜discretionaryâ€™ good, I suspect the industry would have collapsed on itself as customers disgusted by the convoluted and adversarial service they are asked to endure simply said â€˜enough, Iâ€™ll take my money elsewhereâ€¦â€™ There is also the more universal (non-sector specific) issue of the inability of large organisations to avoid suffocating innovation.
So when I read things like this, well I wonder, sadly, if my fears are being fulfilled:
Last.fm didnâ€™t hand user data over to the RIAA. According to our source, it was their parent company, CBS, that did it. That corresponds to what our original source said in conversations we had after our initial post and before CBS lawyers became involved. But we didnâ€™t want to update until we had an independent source for that information, too.
Hereâ€™s what we believe happened: CBS requested user data from Last.fm, including user name and IP address. CBS wanted the data to comply with a RIAA request but told Last.fm the data was going to be used for â€œinternal use only.â€ It was only after the data was sent to CBS that Last.fm discovered the real reason for the request. Last.fm staffers were outraged, say our sources, but the data had already been sent to the RIAA.
At best, CBS is living down to low expectations: once again large corporate antibodies do their best to kill off the virus of innovation.
It’s really sad because last.fm not only has a great product but one where – if CBS spent less time, energy and money on lawyers and corporate pencil pushers – and more on building and promoting the business – they would discover that there are real, paradigm shifting, monetizable business opportunities screaming out to be truly developed. But of course many, perhaps all of these would probably end up destroying the old businesses and ways of operating. Hard to get the turkeys to vote for that…
My last two significant music purchases, and the last live music event I went to were all driven by last.fm. The music purchases were buying (several) albums of a couple artists I had never before heard of which last.fm recommended to me on the basis of my listening history. No way I would have discovered them otherwise. No way. Not at my age anyway. And by the way both of these artists are reasonably obscure – ie have not been promoted up the ying yang by the traditional manufactured music business. So the profit margins are great. No wasted marketing spend. And the “Events recommended for you” functionality is quite frankly unbeatable – geographically and musically relevant. Blows any other events listing service out of the water. Awesome.
I’m a paying customer of last.fm but if packaged in the right way, I’d be happy to pay even more. And it’s not because I’m particularly generous. It’s because they provide a bloody good service and I think it gives value for money. And by the way I’m pretty unhappy about them having sent my listening data to the RIAA. I’m happy and chose to give this data to last.fm because I get value from it and I trust(ed) them. The RIAA? I can’t say anything nice so will leave it at that.
If Apple had bought last.fm it would be ruling the world right now. I wonder if this was ever an option that was on the table?
It’s lovely that you have a website and that you even allow Companies to file (some) documents online. And wait until Google and others find out about your revolutionary business model of paid search! (Imagine if Google caught on and started charging a pound for every search! I can’t believe they didn’t think of this, but think I should buy some shares in case they see this. Just imagine – they would make billions!) Isn’t modern technology wonderful? But although you do seem to be quite ‘au fait’ with this whole internet thingy, there are a couple really neat newfangled things that could make your site even better. Things like relational databases for example. And if you really want to live on the edge, check out what the crazy kids at places like LinkedIn and Facebook have done. And then there’s this stuff called UI and UX, but I understand if you think this is perhaps a step to far. Maybe in 2015. In any event, the blue is very nice. Most people like blue. Very clever! Best regards, – A. Director
Say you are a Director of a UK limited company. Say you are a Director of many UK limited companies. You would think that in 2009, you’d be able to go to the Companies House website and ‘manage your profile’, no? (Address, contact details, present and former Directorships, qualifications, etc.) Well, you’d be wrong. You can’t even search on a person. Only on Companies. God help the poor bastard who is Director of 50 companies and has the stupidity to move: 50 change of address forms to fill in and submit. Online. Sort of. (Only for Limited companies, by post for LLP’s.) Aaaarrgh! I mean c’mon! WTF?!? Just because it is a government organization doesn’t mean it needs to be devoid of innovation, especially since:
The Minister responsible for Companies House is Ian Pearson MP, Minister of State for Science and Innovation. The agency also has Trading Fund status which allows the agency to directly manage its own finances.
Maybe next time he’s in the UK, Reid Hoffman might want to spend an hour with the Companies House Board…(could be mistaken but a cursory google search would suggest that none of the Companies House directors are on LinkedIn so perhaps they do think they are on top of their game…)
In the ten minutes I’ve taken to write this one could sketch out the business model for Companies House 2.0 and given it’s key monopoly status, I’m sure you could build a killer revenue model (without fleecing your customers.) Better service. More revenues. Smarter business.
Better to be wrong collectively than to be right alone is what they say… But I’m just not built that way. Oh and btw, email isn’t just a childish fad either (just in case McKinsey hadn’t cleared that one up too…)
Citigroup (NYSE:C) will begin a new bonus plan aimed at getting its senior executives to work for common earnings improvement across the entire company instead of only driving profits within their departments. According to the FT, the new system is “an effort to increase co-operation and minimize in-fighting among the disparate parts of the sprawling financial services conglomerate.”
Readers won’t be surprised to see me rolling my eyes in disbelief… This is what passes for the leadership for which Citigroup shareholders are paying (hundreds of millions of dollars)?? Did Mr. Pandit expect the stock to bounce on the back of this latest additional coat of shiny eggshell-finish complexity?
However it’s nice to see Mr. Pandit despite living in a house entirely made up of glass (opaque of course) panels, finding the time to wax lyrical about the need for transparency in regulated financial markets. A little bird told me he may have actually just dusted off an old (c. 2005) executive committee strategy document and made a few adjustments to bring it more ‘in line with the prevailing environment’:
Yet transparency is difficult to avoid achieve. It requires continual vigilance to resist standardized products whenever possible appropriate, keeping them away from introducing them to exchanges, resisting creating counterparty clearinghouses and settlement systems and, finally, amassing accurate data on prices and transaction volumes for our proprietary use. Transparency must also include public disclosures to investors about pertinent risk and financial information that give the market the impression it has a chance to make informed judgments.
If I were a Citigroup employee and I read this op-ed, all my fears about my bank being taken over by robots and consultants would have been confirmed at a stroke. Pandit simply doesn’t come across as human in this op-ed: instead he’s some kind of jargon-generation device, talking about “systemic risk umbrellas” and “alternative accounting approaches”.
I stand by my earlier views that – in it’s current configuration – Citgroup is too complex to be efficiently managed, at least using the prevailing standard corporate management paradigm.
Iâ€™m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these â€˜integratedâ€™ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model – while possibly intellectually robust on paper – are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.
Indeed – sticking with the chemical analogy and without writing a book about it – it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etcâ€¦) should naturally â€œdecayâ€ to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants.
I’m sure Mr. Pandit is an extremely intelligent and hard working person, my suspicion however is that will not be sufficient to ensure his success. I certainly don’t envy him, however I wonder if he could be more bold. And I forgive any Citi shareholders for hoping I am sadly misinformed. And I’ll admit that we are now (at 16 and change) closer to the bottom than the top, but I’ll abstain from considering a buy order until I see a material sign of reducing complexity…
Mountainview, CA – Having sold almost 20 million shares in 2004 at $85, and then another 14 million shares at $295 in 2005 (not too mention various block sales over the years), and with shares now trading at over $700 this represents almost $19 billion of lost value. In addition, since the IPO there have been roughly $3.4 trillion of transactions in Google shares on the secondary markets. Obviously it is unacceptable that not a penny of this is returned to the founders and employees of Google. While acknowledging the benefits that the secondary share market offers to investors and companies alike, and admitting (belatedly) that ‘it does not make sense to criminalize Nasdaq’, to redress this shocking state of affairs, the founders’ agents have suggested that they would be willing to authorize it against agreeing to a levy on all transactions. Set at 1% for example this would amount to returning approximately $35 billion to the Google entrepreneurs and their backers. “And this is just one company! Think of all the other entrepreneurs and venture capitalists that have heretofore been exploited by the maverick and rapacious stock market operators,” said Jim Smith of the recently formed Re-sale Rights Committee of the Santa Clara County Chamber of Commerce.
OK, so I made the preceding article up. But, it makes sense right? After all it’s only fair. At least that’s the view of the (always-ahead-of-the-curve) entertainment industry as reported this week in Variety(thanks to Dom for the pointer):
â€œThe secondary ticketing market offers benefits to music fans and the live music industry alike. It does not make sense to criminalize it,â€ said Resale Rights Society chairman-elect Marc Marot, manager of Yusuf Islam and Paul Oakenfold, and former chief executive of Island Records. â€œBut there are real issues of consumer protection here, and it is unacceptable that not a penny of the estimated Â£200 million ($413 million) in transactions generated by the resale of concert tickets in the U.K. is returned to the investors in the live music industry. Where this trade is fair to consumers, we propose to authorize it by agreeing to a levy on all transactions.
â€œThe online ticketing exchanges have consistently claimed that they wish to work with artists and the live music industry. This society presents them with that opportunity.â€
I won’t go into it again in detail (see here and here) but it strikes me that instead of vainly trying to preserve an outdated business model by desperately looking to slap taxes and rents on anything that moves, artists and their agents should be looking to embrace the long proven and manifest advantages of robust, liquid and transparent markets to reduce their risks and refine their pricing. Every syndicate manager knows that having good secondary prices makes their job 100 times easier and – while certainly not the only factor – forms the foundation of the primary market pricing algorithm. And as the traditional securities markets become ever more sophisticated in their use of automation for primary distribution, perhaps the resulting marginalized and surplus syndicate managers should consider plying their skills in the market for live event tickets. The right way to help artists garner the true market value of their talents is to well, let the market work!
And lest anyone in the securities industry feel too smug about how much more enlightened they have always been, remember how Stanley Ross was enemy number one for many in the square mile when he pioneered gray markets 30 odd years ago, and as little as 5 years ago (still today in the US & in Equity markets) electronic bookbuilding platforms were not exactly met with a warm embrace…to use one of Pip Coburn’s favorite quotes on change (Machiavelli):
â€œâ€¦ nothing is more difficult than to introduce a new order. Because the innovator has for enemies all those who have done well under the old conditions and lukewarm defenders in those who may do well under the newâ€¦â€
ABN Amro’s board declined to endorse either of two takeover offers the Amsterdam banking giant has received.
In an update to shareholders on Sunday, the board said it had concluded that the bid from Barclays better fits ABN Amro’s strategy while the one from a group led by Royal Bank of Scotland was riskier but valued higher.
The board said it assessed the deals from the point of view of the interests of the company, shareholders, employees, creditors and clients; the risks of each deal; and corporate governance: the makeup of the board, distribution of managerial positions and other matters.
I wonder who proposed the ‘we don’t know what to do’ motion. I guess the Door number 3 option wasn’t available.
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.)