Tuesday, September 04, 2007

An insider geek comes clean on the chaotic nature of emergent financial instruments

I've not yet read the entire first chapter Big Picture has excerpted, but this is quite remarkable. A geek insider (MIT? Geek.) is telling tales about the complex and recursive financial instruments that have emerged over the past decade...

The Big Picture | A Demon of Our Own Design (Richard Bookstaber)

While it is not strictly true that I caused the two great financial crises of the late twentieth century—the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later—let’s just say I was in the vicinity. If Wall Street is the economy’s powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended. You don’t deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book—it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.

My path to these disasters was more or less happenstance. Shortly after I completed my doctorate in economics at the Massachusetts Institute of Technology and quietly nestled into the academic world, my area of interest—option theory—became the center of a Wall Street revolution. The Street became enamored of quants, people who can build financial products and trading models by combining brainiac-level mathematics with massive computing power. In 1984 I was persuaded to join what would turn out to be an unending stream of academics who headed to New York City to quench the thirst for quantitative talent. On Wall Street, too, my initial focus was research, but with the emergence of derivatives, a financial construct of infinite variations, I got my nose out of the data and started developing and trading these new products, which are designed to offset risk. Later, I managed firmwide risk at Morgan Stanley and then at Salomon Brothers. It was at Morgan that I participated in knocking the legs out from under the market in October 1987 and at Solly that I helped to start things rolling in the LTCM crisis in 1998.

One of my blog posts in waiting is about the vast array of memes arising in the science fiction of the past decade. I can't sort out who contributed what (sorry, I didn't have that kind of memory even when my brain worked), but I recall one author recently tossing off the meme of "Finance 2.0"[1], a tongue-in-cheek portrayal of cyber super-intelligences emerging from the wellspring of financial instruments. I think they attempt to convert the protagonists into cash flow.

I suspect the author is going to tell us that these instruments have evolved beyond our ability to understand them, much less predict their behavior under stress, and that given the extremely rapid pace of their evolution they are likely to have chaotic behaviors. Should be a best seller!

[1] Update 11/20/2010: Charles Stross, Accelerando -- and it was "Economics 2.0", not "Finance 2.0"

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