Through a Frosted Glass, Darkly

In an article published just before Christmas, Lisa Pollack, writing for FT Alphaville
(http://ftalphaville.ft.com/blog/2011/12/23/814381/abstractions-and-morality-in-modern-finance/), posed the question, Why is finance so complex?  She concludes that it may
be due to the “Flynn Effect,” which credits an increase in intelligence, i.e. finance gets more complex because people in finance get smarter and can make it more complex.

In a Boxing Day post, Steve Randy Waldman (http://www.interfluidity.com/v2/2669.html) commented on Ms. Pollock’s conclusion by addressing finance from a different angle:

“Finance has always been complex.  More precisely it has always been opaque, and
complexity is a means of rationalizing opacity in societies that pretend to transparency.” Opacity is absolutely essential to modern finance…The core purpose of status quo financing is to coax people into accepting risks that they would not, if fully informed,
consent to hear” (italics his).

Leaving aside the difference between complexity and opacity for now,  the message here is that if we truly understood the risks we undertook in an investment, we probably would not invest.  This may be true, although one could hardly maintain that man is a rational animal in light of the recent spate of market bubbles and increased volatility. But let’s give Mr. Waldman his due and agree with his premise. In fact, it ties in nicely with
Ms. Pollock’s introduction of the inconsistency that arises in human decision-making.

Here, Mr. Waldman gets a little closer to the prize, given his quote above.  Finance has always been complex. The complexity, and its inherent opacity, has been baked in since more than two people met to do business at the Agora.  Finance is so complex because finance is a complex system.  Moreover, it is a complex adaptive system.  By complex I mean that there are many agents acting on the system in a continuous testing of boundaries from hese agents (rather than from outside sources), creating and created by feedback loops that interact with all the other component parts. In addition,
slight changes in initial conditions can lead to large changes in outcomes (the butterfly effect).

What makes the system adaptive is that it allows for emergent properties. There is no way to know all the possible outcomes as these feedback loops send and receive data from agent to agent, any one of which can react to information in many ways. This reaction is then sent out and each receiving agent may also react in many ways; hence the impossibility of tracking all possible outcomes.  Moreover, the slightest change in any of the inputs changes the outgoing message to all other agents.  We have not even addressed the possibility of messages received in error or interpreted incorrectly, which only increases the potential number of outcomes.

This does make us wish that we could reduce all this to a simple (?) Nash equilibrium, as Mr. Waldman wishes.  Sorry, but in a complex adaptive system, equilibrium is as unlikely as Sisyphus’s rock staying on top of the hill.  He goes on to say that finance is a placebo:

“Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk…We must believe the concoction we are taking to be the product of
brilliant science, the details of which we could never understand.”

From here it is an easy segue back to Ms. Pollock’s belief in the Flynn Effect.  Smarter
people created smarter financial products which only they could understand, and as these products came to be more understood, newer and more complex products
were devised.  This understanding according to Mr. Waldman, remains the province of those within the “brilliant science.”

To both it must be pointed out that even placebos can have side effects.  So when Ms.
Pollock asks:

“Wouldn’t these exceptionally intelligent people be able to see the potential instability they are creating, and the increasingly large potential loss to society as a whole
through bailouts, and the bypassing of the real economy?”

the answer to the first of these questions is no.  There are too many potential
outcomes for the market participants to know which will emerge in the end.  As such, there is no way to know which will cause beneficial results and which will not.
This does not give them a free pass, however.  They should be well aware that risk exists and that some outcomes would range from the unprofitable to the disastrous.

As to the second question, the large potential loss to society is not an issue for them in this age of moral hazard.  In a time when profits are kept and losses distributed, they would think you strange for broaching the question.  These are people who would push the fat man, even if it was their grandfather, as easily as they would pull the lever.

Finally, bypassing the real economy is part of their modus operandi..  As in many instances, some of these detours function quite well, e.g. certain over-the-counter markets.  Others, such as block trading, dark pools, internalized trading and many more, may serve the interests of the insiders to the disadvantage of everyone else.

In the end, I believe that complexity is not the answer. It is not even the question. Rather, why is finance so complicated?  Much of the opacity Mr. Waldman decries and
Ms. Pollock questions is not really the complexity of the market, but in the continually increasing layers of complication we see.  That complex opacity will increase with the number of participants is a mathematical given.

But the opacity in the instruments themselves is not endogenous to the system.  It is exogenous, created by financial engineers searching for a new snake oil formula that can generate profits until others understand it and copy it.  Then a new search begins.

Brilliant science? I think not.  But I do think these market guys are smart enough to stay off bridges.

                                                                                                                                    12.30.11

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