Undoing the pretzel logic of finance

My latest column in Bloomberg came out a few days ago. The article looks at some recent work of young MIT economist Alp Simsek that considers how new derivative instruments influence market stability. He comes to a conclusion that most ordinary people would find utterly unsurprising:

Financial markets in recent years have seen a proliferation of new …financial assets such as different types of futures, swaps, options, and more exotic derivatives. According to the traditional view of …nancial innovation, these assets facilitate the diversi…cation and the sharing of risks. However, this view does not take into account that market participants might naturally disagree about how to value …financial assets. The thesis of this paper is that belief disagreements change the implications of …nancial innovation for portfolio risks. In particular, market participants’' disagreements naturally lead to speculation, which represents a powerful economic force by which fi…nancial innovation increases portfolio risks.

There you go. Because not all people have the same views on the future, derivatives can be used to speculate and gamble. This increases risks in the market. More derivatives and more complete markets is not always a good thing, as standard financial theory would have it.

To be clear, I'm not poking fun at Simsek's work. Not at all. I think this work should be spread far and wide. That this idea comes as news to the academic finance community shows how deeply confused they have become by the received wisdom of market completeness as an ideal. They (at least many) do believe that UP = DOWN, and so news to the contrary sounds radical. In the article I've mentioned several other earlier studies (I've written about them here before, just search on "derivatives") that point to the same conclusion: more derivatives in general leads to more market instability (again, as most people already believe).

It's nice to see some influential young economists picking up and exploring this idea.

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Networks in finance

Just over a week ago, the journal Nature Physics published an unusual issue. In addition to the standard papers on technical physics topics, this issue contained a section with a special focus on finance, especially on complex networks in finance. I'm sure most readers of this blog won't have access to the papers in this issue, so I thought I'd give a brief summary of the papers here.

It's notable that these aren't papers written just by physicists, but represent the outcome of collaborations between physicists and a number of prominent economists (Nobel Prize winner Joseph Stiglitz among them) and several regulators from important central banks. The value of insight coming out of physics-inspired research into the collective dynamics of financial markets is really starting to be recognized by people who matter (even if most academic economists won't wake up to this probably for several decades).

I've written about this work in my most recent column for Bloomberg, which will be published on Sunday night EST. I was also planning to give here some further technical detail on one very important paper to which I referred in the Bloomberg article, but due to various other demands in the past few days I haven't quite managed that yet. The paper in question, I suspect, is unknown to almost all financial economists, but will, I hope, gain wide attention soon. It essentially demonstrates that the theorists' ideal of complete, arbitrage free markets in equilibrium isn't a nirvana of market efficiency, as is generally assumed. Examination of the dynamics of such a market, even within the neo-classical framework, shows that any approach to this efficient ideal also brings growing instability and likely market collapse. The ideal of complete markets, in other words, isn't something we should be aiming for. Here's some detail on that work from something I wrote in the past (see the paragraphs referring to the work of Matteo Marsili and colleagues).

Now, the Nature Physics special issue.

The first key paper is "Complex derivatives," by Stefano Battiston, Guido Caldarelli, Co-Pierre Georg, Robert May and Joseph Stiglitz. It begins by noting that the volume of derivatives outstanding fell briefly following the crisis of 2008, but is now increasing again. According to usual thinking in economics and finance, this growth of the market should be a good thing. If people are entering into these contacts, it must be for a reason, i.e. to hedge their risks or to exploit opportunities, and these deals should lead to beneficial economic exchange. But, as Battiston and colleagues note, this may not actually be true:

By engaging in a speculative derivatives market, players can potentially amplify their gains, which is arguably the most plausible explanation for the proliferation of derivatives in recent years. Needless to say, losses are also amplified. Unlike bets on, say, dice — where the chances of the outcome are not affected by the bet itself — the more market players bet on the default of a country, the more likely the default becomes. Eventually the game becomes a self-fulfilling prophecy, as in a bank run, where if each party believes that others will withdraw their money from the bank, it pays each to do so. More perversely, in some cases parties have incentives (and opportunities) to precipitate these events, by spreading rumours or by manipulating the prices on which the derivatives are contingent — a situation seen most recently in the London Interbank Offered Rate (LIBOR) affair.

Proponents of derivatives have long argued that these instruments help to stabilize markets by distributing risk, but it has been shown recently that in many situations risk sharing can also lead to instabilities.

The bulk of this paper is devoted to supporting this idea, examining several recent independent lines of research which indicate the more derivatives can make market less stable. This work shares some ideas with theoretical ecology, where it was once thought (40 years ago) that more complexity in an ecology should generally confer stability. Later work suggested instead that complexity (at least too much of it) tends to breed instability. According to a number of recent studies, the same seems to be true in finance:

It now seems that the proliferation of financial instruments induces strong fluctuations and instabilities for similar reasons. The basis for pricing complex derivatives makes several conventional assumptions that amount to the notion that trading activity does not feed back on the dynamical behaviour of markets. This idealized (and unrealistic) model can have the effect of masking potential instabilities in markets. A more detailed picture, taking into account the effects of individual trades on prices, reveals the onset of singularities as the number of financial instruments increases.

The remainder of the paper goes on to explore various means that may be taken, through regulations, to try to manage the complexity of the financial network and encourage its stability. Stability isn't something we should expect to occur on its own. It demands real attention to detail. Blind adherence to the idea that "more derivatives is good" is a recipe for trouble.

The second paper in the Nature Physics special issue is "Reconstructing a credit network," by Guido Caldarelli, Alessandro Chessa, Andrea Gabrielli, Fabio Pammolli and Michelangelo Puliga. This work addresses an issue that isn't quite as provocative as the value of the derivatives industry, but the topic may be of extreme importance in future efforts to devise effective financial regulations. The key insight coming from network science is that the architecture of a network -- its topology -- has a huge impact on how influences (such as financial distress) spread through the network. Hence, global network topology is intimately linked up with system stability; knowledge of global structure is absolutely essential to managing systemic risk. Unfortunately, the history of law and finance is such that much of the information that would be required to understand the real web of links between financial institutions remains private, hidden, unknown to the public or to regulators.

The best way to overcome this is certainly to make this information public. When  financial institutions undertake transactions among themselves, the rest of us are also influenced and our economic well being potentially put at risk. This information should be public knowledge, because it impacts upon financial stability, which is a public good. However, in the absence of new legislation to make this happen, regulators can right now turn to more sophisticated methods to help reconstruct a more complete picture of global financial networks, filling in the missing details. This paper, written by several key experts in this technical area, reviews what is now possible and how these methods might be best put to use by regulators in the near future.

Finally, the third paper in the Nature Physics special issue is "The power to control," by Marco Galbiati, Danilo Delpini and Stefano Battiston. "Control" is a word you rarely hear in the context of financial markets, I suppose because the near religion of the "free market" has made "control" seem like an idea of "communists" or at least "socialists" (whatever that means). But regulation of any sort, laws, institutions, even social norms and accepted practices, all of these represent some kind of "control" placed on individuals and firms in the aim, for society at large, of better outcomes. We need sensible control. How to achieve it?

Of course, "control" has a long history in engineering science where it is the focus of an extensive and quite successful "control theory." This paper reviews some recent work which has extended control theory to complex networks. One of the key questions is if the dynamics of large complex networks might be controlled, or at least strongly steered, by influencing only a small subset of the elements making up the network, and perhaps not even those that seem to be the most significant. This is, I think, clearly a promising area for further work. Let's take the insight of a century and more of control theory and ask if we can't use that to help prevent, or give early warnings of, the kinds of disasters that have hit finance in the past decade.

Much of the work in this special issue has originated out of a European research project with the code name FOC, which stands for, well, I'm not exactly sure what it stands for (the project describes itself as "Forecasting Financial Crises" which seems more like FFC to me). In any event, I know some of these people and apart from the serious science they have a nice sense of humor. Perhaps the acronym FOC was even chosen for another reason. As I recall, one of their early meetings a few years ago was announced as "Meet the FOCers." Humor in no way gets in the way of good science.

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ISDA: Stop Making Sense

The following is a response I just posted on Bloomberg to some criticism last week coming from the International Swaps and Derivatives Association. They took issue with some things I had written in my latest Bloomberg column. I think their comment was partially fair, and also partially misleading, so I thought some clarification would be useful. The text below is identical to what appears (or will very shortly) in Bloomberg:

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My most recent Bloomberg column on the network of credit default swaps contracts provoked a comment from the International Swaps and Derivatives Association, Inc. The group objected to my characterization of the network of outstanding CDS contracts as "hidden" and potentially a source of trouble. I'd like to address their concerns, and also raise some questions.

Contrary to the association's claim, I am aware of the existence of the Depository Trust & Clearing Corporation. I'll admit to having underestimated how much their project to create a warehouse of information on CDS contracts has developed in the past few years; my statement that these contracts are not "recorded by any central repository" was too strong, as a partial repository does exist, and the DTCC deserves great credit for creating it.

However, it is not clear that this repository gives such a complete picture of outstanding CDS linkages that we can all relax.

For example, DTCC's repository covers 98 percent of all outstanding CDS contracts, not 100 percent. Asking why may or may not be a quibble. After all, a map showing 98 percent of the largest 300 cities in the U.S. could leave out New York, Los Angeles, Chicago, Houston and Philadelphia. Moreover, the simple number of contracts tells us nothing about the values listed on those contracts. In principle, the missing 2 percent of contracts could represent a significant fraction of the outstanding value of CDS contracts.

More importantly, when thinking about potentially cascading risks in a complex network, fine details of the network topology -- its architecture or wiring diagram -- matter a lot. Indeed, the CDS contracts that put American Insurance Group Inc. in grave danger in 2008 represented a tiny fraction -- much less than 1 percent -- of the total number of outstanding CDS contracts.

Hence, it would be interesting to know why the repository holds only 98 percent rather than 100 percent. There may be a very simple and reassuring answer, but it's not readily apparent from DTCC's description of the repository.

Also, there is another issue which makes "fully transparent" not quite the right phrase for this network of contracts, even if we suppose the 98 percent leaves out nothing of importance.

The DTCC commendably makes its data available to regulators. Still, it appears that the full network of interdependencies created by CDS contracts may remain opaque to regulators, because DTCC, according to its own description, enables...

"... each regulator to access reports tailored to their specific entitlements as a market regulator, prudential or primary supervisor, or central bank. These detailed reports are created for each regulator to show only the CDS data relevant to its jurisdiction, regulated entities or currency, at the appropriate level of aggregation."

This would imply, for example, that regulators in the U.S. can look and see which of their banks have sold CDS on, say, a big German bank. But the health of the U.S. banks then depends directly on the health of that German bank, which may in turn have sold CDS on Greek or Italian debt or any number of other things. The DTCC data on the latter CDS contracts would, apparently, not be available to U.S. regulators, being out of their jurisdiction.

The point is that a financial institution is at risk not only from contracts it has entered into, but also from contracts that its many counterparties have entered into (this is the whole idea of systemic risk linked to the possibility of contagion). Credible tests of the financial network's resilience require a truly global analysis of the potential pathways along which distress (particularly from outright counterparty failures) may spread. It's not clear that any regulator has the full data on which such an analysis can be based.

None of this, by any means, is meant as a criticism of DTCC or what it has done in the past few years. The 98 percent figure is impressive, and let's hope the 98 percent soon becomes 100 percent and the DTCC finds a way to make ALL information in the repository available to regulators everywhere. Even better would be full disclosure to the public.

Of course, nothing in the comment from the International Swaps and Derivatives Association changes the main point of my column, which was that it is incorrect to believe that more CDS contracts -- or, more generally, more financial interdependencies of any kind, including links created by other derivatives such as interest-rate swaps -- automatically lead to better risk-sharing and a safer banking system. More apparent risk-sharing can actually mean more systemic risk and less overall banking safety.

(Mark Buchanan is a Bloomberg View columnist.)

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The long history of options

I just finished reading Niall Ferguson's book The Ascent of Money, which I strongly recommend to anyone interested in the history of economics and especially finance. Some readers of this blog may suspect that I am at times anti-finance, but this isn't really true. Ferguson makes a very convincing argument that finance is a technology -- a rich and evolving set of techniques for solving problems -- which has been as important to human well-being as knowledge of mechanics, chemistry and fire. I don't think that's at all overstated -- finance is a technology for sharing and cooperating in our management of wealth, savings and risk in the face of uncertainty. It's among the most basic and valuable technologies we possess.

Having said that, I am critical of finance when I think it is A) based on bad science, or B) used dishonestly as a tool by some people to take advantage of others. Naturally, because finance is complicated and difficult to understand there are many instances of both A and B. And of course one often finds concepts from category A aiding acts of category B.

But one thing I found particularly interesting in Ferguson's history is the early origins of options contracts and other derivatives. The use of derivatives has of course exploded since the work of Black and Scholes in the 1970s provided a more or less sensible way to price some of them. It's easy to forget that options have been around at least since the mid 1500s (in Dutch and French commodities markets). They were in heavy use by the late 1600s in the coffee houses of London were shareholders traded stocks of the East India Company and roughly 100 other joint-stock companies.

Looking a little further, I came across this excellent review article on the early history of options by Geoffrey Poitras of Simon Fraser University. This article goes into much greater detail than Ferguson on the history of options. As Poitras notes, early use in commodities markets arose quite naturally to meet key needs of the time (as any new technology does):

The evolution of trading in free standing option contracts revolved around two important elements: enhanced securitization of the transactions; and the emergence of speculative trading. Both these developments are closely connected with the concentration of commercial activity, initially at the large medieval market fairs and, later, on the bourses. Though it is difficult to attach specific dates to the process, considerable progress was made by the Champagne fairs with the formalization of the lettre de foire and the bill of exchange, e.g., Munro (2000). The sophisticated settlement process used to settle accounts at the Champagne fairs was a precursor of the clearing methods later adopted for exchange trading of securities and commodities. Over time, the medieval market fairs came to be surpassed by trade in urban centres such as Bruges (de Roover 1948; van Houtte 1966) and, later, in Antwerp and Lyons. Of these two centres, Antwerp was initially most important for trade in commodities while Lyons for trade in bills. Fully developed bourse trading in commodities emerged in Antwerp during the second half of the 16th century (Tawney 1925, p.62-5; Gelderblom and Jonker 2005). The development of the Antwerp commodity market provided sufficient liquidity to support the development of trading in ‘to arrive’ contracts. Due to the rapid expansion of seaborne trade during the period, speculative transactions in ‘to arrive’ grain that was still at sea were particularly active. Trade in whale oil, herring and salt was also important (Gelderblom and Jonker 2005; Barbour 1950; Emery 1895). Over time, these contracts came to be actively traded by speculators either directly or indirectly involved in trading that commodity but not in need of either taking or making delivery of the specific shipment.

 Another interesting point is the wide use in the 1500s of trading instruments which were essentially flat out gambles, not so unlike the credit default swaps of our time (ostensibly used to manage risk, but often used to make outright bets). As Poitras writes,

The concentration of liquidity on the Antwerp Exchange furthered speculative trading centered around the important merchants and large merchant houses that controlled either financial activities or the goods trade. The milieu for such trading was closely tied to medieval traditions of gambling (Van der Wee 1977): “Wagers, often connected with the conclusion of commercial and financial transactions, were entered into on the safe return of ships, on the possibility of Philip II visiting the Netherlands, on the sex of children as yet unborn etc. Lotteries, both private and public, were also extremely popular, and were submitted as early as 1524 to imperial approval to prevent abuse.”

 One other interesting point (among many) is the advice of observers of the 17th century options markets to use easy credit to fund speculative activity. A man named Josef de la Vega in 1688 wrote a book on the markets called Confusion de Confusiones (still an apt title), and offered some fairly reckless advice to speculators:

De la Vega (p.155) goes on to describe an even more naive trading strategy: “If you are [consistently] unfortunate in all your operations and people begin to think that you are shaky, try to compensate for this defect by [outright] gambling in the premium business, [i.e., by borrowing the amount of the premiums]. Since this procedure has become general practice, you will be able to find someone who will give you credit (and support you in difficult situations, so you may win without dishonor).”

The possibility that the losses may continue is left unrecognized.

Or, of course, perhaps the possibility of continuing losses was recognized, and it was also recognized that these losses would in effect belong to someone else -- the person from whom the funds were borrowed.

These points aren't especially important, but they do bring home the point that almost everything we've seen in the past 20 years and in the recent financial crisis have precursors stretching back centuries. We're largely listening to an old tune being replayed with modern instruments.

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How derivatives make markets unstable: Part I

I posted a while back on some of the dirty secrets of the derivatives industry. I promised then to give a little more discussion at some point of two terrifically important pieces of research -- still not widely known, especially in mainstream finance -- which show how adding more derivatives to a market can make it less stable, not more stable. This goes directly against the received wisdom of economic (equilibrium) theory which claims that markets become more efficient as they become more complete, i.e. as it becomes possible to take essentially any kind of market position by virtue of a dense spectrum of financial instruments.

One of the papers I had in mind was this landmark study from several years ago in which William Brock, Cars Hommes and Florian Wagener considered the question of whether, in the run up to the recent crisis, "... highly leveraged positions using complex financial instruments may have amplified market volatility." The answer to which their analysis leads is -- yes, quite probably. More generally, they illustrate how more derivatives in general should make markets more unstable, increasing volatility.

Their paper is a little technical, but worth a read. I'll outline the gist of their argument, which starts with several straightforward observations and moves to a not-so-obvious conclusion:

Observation 1: They start by noting that people aren't the hyper-rational automatons of Milton Friedman's (or other neo-classical economists') favorite fantasies. Rather, people in the real world form their expectations and craft their behaviour in an adaptive way -- that is, they learn from experience.

Observation 2: They also note that people aren't identical. We not only learn, but our brains are different and we've all had different experiences in the past, so, at any moment, we've probably learned different things and have slightly different expectations (heterogeneous expectations, in economic lingo) about the future.

Observation 3: People are generally risk averse -- if they're willing to bet $100 on a gamble that could pay off, but involves risks, they'll be willing to bet more than $100 in the same gamble if you reduce the risks. In other words, people shy away from gambles more the riskier they are. This is basic empirical psychology.

Starting from these observations, Brock and colleagues then consider an "intertemporal" asset market (economist-speak meaning a market in which time exists) in which a lot of people look to past prices and try to predict future prices, buying and selling as they see fit. This market contains both risky and non-risky things to invest in -- stocks and risk-free bonds (which are guaranteed to increase in value by a factor R>1 over each interval of time). Stocks might rise more, but are less certain and hence riskier. In addition, the people can buy derivatives -- instruments which act like pure bets and give a pay off in certain circumstances.

What this all amounts to is that people in this market can 1) play it safe by buying bonds, 2) gamble more by buying stocks, and also 3) buy derivatives if they want which (in this model) have no effect except to offset some of the risks involved in buying stocks.

What Brock and colleagues then show is that the combination of the derivatives, the risk aversion of investors, and their tendency to learn by "reinforcement" -- to be more likely to follow strategies which have paid off in the past -- leads directly to trouble. I'll describe how in a moment, but one final thing before I do: the strength of reinforcement learning in the model (how quickly people shift to use better performing strategies) is controlled by one parameter β; bigger β means faster switching. In previous work, Brock and Hommes have shown that in an asset market in which people learn by the reinforcement process, there is a natural "tipping point" -- at a certain critical value of β -- where the market goes from being stable to being unstable. Intuitively, when people switch too quickly, taking even scanty short term evidence as proof of a strategy's superiority, fluctuations in the market become much stronger.

OK, so what happens in this market when you currently have, say, 15 possible derivatives covering lots of different possible outcomes, and now add a 16th derivative to cover other outcomes (i.e. we have derivatives on stocks and commodities, and suddenly invent some new ones to cover mortgage bonds)? Brock and colleagues show that the addition of this one new derivative makes the market go unstable more quickly, i.e. at a lower value of β. The mechanism involves a simple interplay of reduced risk and human confidence. This new derivative, by making it possible for investors to lower the risks associated with investments, leads them to invest more money. They take bigger bets. These bigger bets naturally amplify how quickly the bets that turn out to be correct amass profits. So, there are bigger differences in the payoffs to recent winning and losing strategies, which draws more followers to the winners more quickly (even if the fundamental switching rate of people haven't changed).

In brief: by the very act of reducing the risk of some strategies, the derivative invites more vigorous gambling on that strategy, leading to faster flows of people from one strategy to another. The extra derivative makes the market more volatile.

This model doesn't involve many questionable assumptions. It's a very basic model of the most central facts of any market, respecting some realities of human psychology. It suggests that derivatives hold inherent dangers. Yet as far as I can see, the ongoing discussion of regulating derivatives isn't taking this perspective into account. As Satyajit Das notes, the drive toward greater returns that is an essential part of the dynamics in the Brock, Hommes and Wagener model is a very real force in today's derivatives markets:

Investors searching for return drive speculation. Concerned about stagnant real incomes and inadequate retirement savings, individual investors seek out higher yielding investment structures, often based on derivatives. Pension funds and other institutional investors use derivatives to enhance returns to fully fund and meet their contracted liabilities. In an environment of diminishing returns and fierce competition for attractive investments, fund managers use derivative strategies to enhance returns through readily accessible leverage and capacity to create risk “cocktails”.

Facing increased pressure on earnings, corporations have increasingly “financialised”, resorting to speculative derivative trading to meet profit expectations. ... [Such] seculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies.

What happens in the real world backs up the lesson of this simple model. Derivatives reduce risks only in a very narrow and restricted sense, while undermining the functioning of markets more generally. Of course, there's lots of money to be made by the people selling derivatives, so don't expect them to admit (or care about) any of this.

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