Built to Crash?

In a brilliant book “A demon of our own design”, the author, Richard Bookstaber, concludes on what is wrong with the current ﬁnancial system and how it has become more crisis – prone.

“The question posed by this book, simply put, is: Why can’t the financial markets seem to get their act together? Why, in spite of reduced risk in the underlying economy, in spite of the march of innovation and the contributions of financial engineering, do we not enjoy reductions in financial risk that we find in other areas of our lives? Why are markets actually becoming more crisis-prone?

One answer can be found in the effects of innovation. It is undeniable that innovation has had some positive effects on the markets. It has improved the markets by making them mechanically more efficient. The markets are more liquid and quicker to react to information. Information flows more freely and is distributed more widely, and prices are readily available to virtually all participants. Trades are executed nearly instantaneously worldwide at transaction costs that are a small fraction of what they were a few decades ago. And, whether developed with the intent of better meeting the demands of investors or, more cynically, to stave off commoditization and maintain profitability, we are awash in new and innovative instruments.

But the positive effects of innovation come at a price. Innovation increases complexity. Many innovative instruments are in the form of derivatives with conditional and nonlinear payoffs. When a market dislocation arises, it is difficult to know how the prices of these instruments will react. Innovation and mechanical efficiency have also increased complexity by pushing markets to become more interconnected. Thanks to globalization, a problem in one market can affect another even when there is no economic relationship between the two simply because investor portfolios or bank credit lines have exposures to each. Innovation has also led the markets to become more tightly coupled. This tight coupling, and the resulting higher liquidity, makes it is easier to take on levered positions, because more liquid and readily priced securities make for better collateral.

The combination of tight coupling and complexity is a formula for normal accidents-accidents that are all but inevitable as a result of the structure of the system. We have analyzed these sorts of accidents in airlines with the ValuJet crash and in nuclear power plants with Three Mile Island and < ?xml:namespace preﬁx = st1 ns = "urn:schemas-microsoft-com:oﬃce:smarttags" />Chernobyl. In all of these cases disaster was triggered by simple and apparently innocent actions that initiated a chain of compounding problems because of the complex nature of the system. The tight coupling from one link to the next precluded any kind of stop lever; no one could sit back and say, “Wait a minute, let’s shut things down and think about what is happening here.” What is all the more troubling is that attempts to add layers of safeguards or regulation to prevent these disasters may actu-

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ally do the opposite by increasing the complexity. The catalyst for the ValuJet crash was a regulated safeguard. The problems at Chernobyl started with a safety test.

Financial risk is also higher because the markets increasingly assume a mathematically precise rationality, as opposed to the way we actually do, or indeed really should, behave. People do crazy things all the time, yet the efficient market paradigm assumes that investors take all information into account and react quickly and rationally. The world is not well described by this paradigm; we tend to be coarse in our responses and we leave information by the wayside. We do this because we conduct our lives with a sense of unanticipatable, primal risk that remains unconsidered in the market’s design. Recall the cockroach-scurrying along over millions of years, as jungles turn to deserts and cities rise and fall, ignoring most of the information the environment has to offer- versus the furu, optimized and specialized to take advantage of every nook and cranny of its niche in Lake Victoria. We are wired to deal with a type of uncertainty we cannot recognize, and this leads us to exhibit behavior that is inconsistent with the mathematical rationality that underlies the paradigm on which financial engineering is based. We fail to take the degree of fine-tuned actions that conventional optimization would dictate, and fortunately so, be cause, like the furu, conventional optimization pairs off only against the current world with the risks and uncertainties that can be identified within it.

The implications of this uncertainty are profound, extending beyond the financial markets. But because the markets feed on risk and are largely free of friction and institutional constraints, apparently suboptimal behavior may have its most significant and obvious effects there. For example, coarse behavior leads to a paradoxical corollary: Greater uncertainty leads to more predictable behavior. Within the limited world of finance, this predictability is a decided negative. It might be the reason traders and hedge funds can pick us off to make profits. But within the broader world in which we live, and the many possible worlds that might unexpectedly arise, this predictability and the coarse behavior from which it stems leaves us-and our biological compatriots- more capable of survival.

Market crises are not born from nature. They are not transmitted by economic or natural catastrophe. The machinery of the market itself can take a small event and distort it. The more closely we try to follow the ideal, thereby adding complexity and more tightly coupling the actions of the market, the more frequently crises will occur. Attempts at that point to add safety features, to layer on regulations and safeguards, will only add to the complexity of the ‘system and make the accidents more frequent. And when blowups happen in the future I can guarantee that the focus will be directed improperly: not at the issues of market design but at hedge funds where the events are observed. They will be implicated for the simple reason that they are engulﬁng more and

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more of the risk-taking landscape. The perception of hedge funds being what it is, they will take the blame and become subject to increased regulation. But blaming hedge funds is a little bit likeThe Simpsons episode in which a meteorite hits Springﬁeld and the townspeople gather, shouting, “Let’s burn down the observatory so this never happens again!” True, the hedge funds are the institutions that have the appetite for the risk; but there is nothing inherent in hedge funds, nothing that they represent as a uniﬁed set, that makes them the singular cause of anything.

So if we are subject to risks that we cannot even anticipate, if we have built a world of complexity and tight coupling where adding regulation only makes matters worse, is there any more we can say other than “get used to it”?

In the basement of a rundown oﬃce building on West 30th Street in New York‘s Garment District resides Renzo Gracie’s Brazilian Jiu Jitsu Academy. It is not only a place where I train several times a week, but one that also oﬀers a great lesson in demonstrating a method for dealing with the endogenous risk of the market.

How ‘Jiu Jitsu” and “Brazilian” came to be joined in one breath is an interesting story.In 1912 a large group of Japanese immigrated to northern Brazil. They were assisted by Mitsuyo Maeda, a noted Japanese jujitsu expert who had traveled throughout the Americas and Europe teaching the art before emigrating to Brazil. Gastao Gracie, a diplomat and businessman, had befriended Maeda and arranged for the group’s immigration. To show his appreciation, Maeda taught jujitsu to Gastao’s oldest son, Carlos Gracie. He was just14 when he began. A dedicated student, he adapted Maeda’s techniques to be more effective for fighting in the Brazilian streets. He not only entered competitions, but also advertised in newspapers to find opponents against whom he could test and improve his style. Later he taught his younger brothers, the youngest of whom, Helio, became especially adept. Helio had a slight build, and to accommodate his small size and lack of strength he further modified the jujitsu style, focusing more on technique and less on power or athleticism. Helio fought more than 600 matches with only two defeats, both occurring when he was past the age of 45. The techniques refined by Carlos and Helio were passed on to their children and through them to the next generation as well. Carlos had 21 children and Helio had 9, so a dynasty of Brazilian Jiu Jitsu fighters was born. Today there are more than 40 Gracie family members who either teach or compete, Renzo being one of their number.

The conﬁdence of the Grades was manifest in an open challenge: Anyone could walk into their academy and demand a ﬁght on the spot, with no time limit and no rules. Any challenger’s notion of engaging in a bare- knuckle slugfest would be quickly disarmed by the nature of Brazilian Jiu Jitsu. Little if any damage would occur

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before the Gracies would take the fight to the ground. Once there, it would end with submission from either a choke hold or a joint lock. The opponent, sensing he would shortly lose consciousness in the first instance or would have his arm broken in the second, would “tap out” on the floor to signal his desire to end the contest. It made the challenge workable both for the Grades and for their foes. There was no harm done, but the superiority of the Gracie techniques was made clear. Over time these sorts of one-on-ones expanded to take place in open, no-holds-barred competitions calledvale tudo, Portuguese for “anything goes,” which became common throughout Brazil as a practical testing ground. These competitions came to the United States in 1994 when Rorion and Royce Gracie, two of Helio’s sons, promoted mixed martial arts tournaments in thevale tudo tradition to demonstrate to the world at large the domination that Brazilian Jiu Jitsu had enjoyed in Brazil for the better part of a century.

The very existence of vale tudo competition points to the key aspect of Brazilian Jiu Jitsu that allowed it to gain superiority over other martial arts. It was not just that it was actively improved through competition while other forms stayed rooted in tradition. It was that it had been developed in a way that allowed this competition and testing to occur in the ﬁrst place. The techniques that formed the basis of Brazilian Jiu Jitsu could be practiced without causing harm. Many ﬁghting techniques cannot be practiced live because they inevitably cause injury. The genius behind the development of Brazilian Jiu Jitsu was to select for inclusion only those techniques that are applied in a slow and measured way so that an opponent can stop before injury occurs.

What became apparent over time was that having a firm understanding of the actual application of a set of controlled techniques through live training and real fights was superior to having a quiver filled with techniques that were powerful in theory but could not be tried and refined until an actual fight occurred. You can see where this is leading when it comes to the markets. Does it make sense to do the same thing? Should we pull away from dangerous innovations, even if those innovations appear to be useful? And what constitutes those that are dangerous?

I believe the markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have. Just because you can turn some cash flow into a tradable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so. Well, in the efficient market paradigm it does, because there nirvana is attained when a position can be taken against every possible state of nature. But in the world of normal accidents and primal risk, limitless trading possibilities might cause more harm than good. Each innovation adds layers of increasing complexity and tight coupling.

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And these cannot be easily disarmed through oversight or regulation. If anything, attempts at regulating a complex system just makes matters worse. Furthermore, if an innovation is predicated on behavior predicted by the eﬃcient markets theory, then things may not operate as advertised: People just don’t behave that way. The point is that these innovations have externalities for the entire ﬁnancial system that are hard to measure but dominate their apparent value. Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.

Linked to the need to reduce market complexity is the need to relax tight coupling. The easiest course for reducing tight coupling it to reduce the speed of market activity. This has been done in times of crisis through the imposition of bank holidays and so-called circuit breakers, but doing so on a day-to-day basis would turn back the clock on ﬁnancial markets in an unacceptable way. A less disruptive course of action is to reduce the amount of leverage that comes as a result of the liquidity, since this is ultimately the culprit that high liquidity and speed of execution breeds. The externalities to high leverage are greater than they appear, because on most days everything runs smoothly. But as we have seen time and again, in the instances where it really matters the liquidity that is supposed to justify the leverage will disappear with a resulting spiral into crisis.

Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets. These modifications will lead to a financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But, like the coarse response mechanism of the cockroach, when faced with the inevitable march of events that we cannot even contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable.”