Hunting The Next Black Swan
Interesting story on NPR this afternoon that relates to the prospects for improved financial market regulatory reform.
What do sardine populations, Wall Street and Antarctica have in common? The answer is, they can all reach a critical moment — a tipping point — and change dramatically and unexpectedly.
Fish populations can crash. Markets can, too. And Antarctic ice shelves can melt with little warning. Those sudden changes can have an enormous impact, so it would be great to know about them before they happened.
The story is about mathematicians that seem to be getting better at creating models that predict tipping points, the point at which a stable system (could be biological, financial, social, whatever) suddenly becomes unstable. The orign and motivation for much of this work is the study of animal populations and other environmental applications, but those of us that follow markets closely can see where this is headed.
Some quant that only other quants can (initially) understand will create a tipping point model that can be shown to accurately predict tail events, Black Swans in the current lingo. The quant will go to New York or London, get hired by a hedge fund or bank proprietary trading desk, and make a lot of money. Other quants will piece together the algorithm, the essentials of which will be published in a leading academic journal, and copy or create their own tipping point model. At first the new algorithms will be used sensibly, but with the new money making technique spreading like wildfire, it won’t be long before one or more of several things happen.
- Hedge funds and other prop desks take on more risk
- Institutional investors of all kinds are educated on, sold and begin to buy overlay strategies that immunize them from tail risk
- Fixed income and mortgage gurus use the models to create billions of dollars of “immunized” higher credit quality securities
- The new algorithms facilitate unregulated, over-the-counter trading in innovative swaps and new derivatives
- The Basel Committee on Banking Supervision (authors of the Basel I and II bank capital accords) is persuaded that global banks can issue new “immunized” senior unsecured debt securities backed or priced using the algorithm
- It is discovered that the algorithms can not only predict tipping points but drive trading strategies that create tipping points in stocks, bonds, currencies or commodities
- Several rogue traders at different firms around the global gang up to create an unexpected bubble or a collapse in some large liquid market like sovereign bonds, oil, gold or currenices
- There are some big expensive accidents causing a bank or hedge fund to collapse
- The next 9/15/2008?
I could go on. Point is, the next innovation that re-defines capital issuance, risk and risk taking is always just around the corner. I’ve heard a lot of ideas but no good ways to re-regulate our banking system and capital markets to maintain the current structure of everybody gets to do everything: from taking deposits and clearing checks to underwriting securities and running proprietary trading desks. If we want a financial system that serves society instead society and taxpayers creating tons of debt to bail out an errant financial sector then we need to return to the kind of risk taking separation envisioned in the Banking Act of 1933, aka Glass-Steagall.
