Collapsing under its own weight
Andrew Lo, director of MIT’s Laboratory for Financial Engineering describes how one rogue trader can impact global markets. Why? Because the software and systems on which it runs have become increasingly complex. And that means that a small change in the initial conditions can have unexpected consequences.
Interviewer: "Okay, so bad things will happen. I take it you are mainly concerned about the ripple effect when they do?"
Andrew Lo: "Exactly. The financial system as a whole is getting more complex. Financial institutions rely on ever more elaborate systems architecture and electronic communications across different counterparties and sectors. The number of parties involved, the nature of transactions, the volume of transactions as the market grows--taken together, the dynamics among these aspects of financial markets imply that the complexity is growing exponentially. No single human can comprehend that complexity. And as the system grows more complex, it is a well-known phenomenon that the probability of some kind of shock spreading through the system increases as well. Systemic shocks become more likely. Today, we are looking at some significant exposure to relatively rare events."
Andrew Lo was particularly disturbed by suggestions that a rogue trader, Jerome Kerviel at Societe Generale could hand-change records in their database system. "From news reports, it appears he was able to access internal financial databases and not only alter the stated holdings of the accounts he was trading, but was also able to circumvent the checks and reconciliation processes that were put into place to make sure these were accurate." The fraudulent trades Kerviel conducted may have actually triggered a worldwide "unwinding" of portfolios. "It's a larger-scale version of what happened in August of 2007--in particular, August 7, 8, and 9. A large number of quantitative equity hedge funds lost money on those dates simultaneously, yet there is no market event that you can point to that can explain why these funds lost money at the same time."
So what does Andrew Lo propose? A Capital Markets Safety Board, which like the NTSB, should look into every crash, not of the airframe variety, but of the financial kind, to make sure there isn't some systemic defect lurking under the code.
But will adding safety modules to the financial system help? Commenter Henkeeper in a previous thread points out that when complex systems are made even more complicated by additional safety systems sometimes their propensity to crash actually increases, citing Charles Perrow's book Normal Accidents.Perrow argued that "improvements may introduce new opportunities for disaster. Looking at an array of real and potential technological mishaps--including the Bhopal chemical-plant accident of 1984, the Challenger explosion of 1986, and the possible disruptions of Y2K and genetic engineering--Perrow concludes that as our technologies become more complex, the odds of tragic results increase. ... the Chernobyl nuclear accident, to name one recent disaster, was partially brought about by the failure of a safety system that was being brought on line."