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Wednesday, April 02, 2008

On Markets and Complexity

Continued from page 1

By Nate Nickerson
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TR: So why aren't we safer?

RM: You have to ask, What have we done with all of these improvements? We've gone to much greater complexity. We have many more instruments. Firms and individuals have been more willing to cut back on their equity cushions and leverage more. To go back to our car analogy, we're more willing to drive faster because of the better tools at our disposal and great transparency.

TR: So where does complexity come into all this?

RM: Sometimes the term "complex" is used as a euphemism for "less-well understood." People sometimes say, "Things have gotten more complex," but what they're really saying is, "I understand things less well."

TR: But in your time, have things gotten a lot more complex?

RM: Yes, they have. Let me give you an extreme example. For certain very specialized hedge funds that do what's called very high frequency trading, the location of the outsider's server and the exchange's server matters.

TR: It's that tight.

RM: Yes--speed of light. So in fact one of the exchanges used to delay just slightly the information going out from the East Coast to allow a little more parity for those on the West Coast. Today, they rent or auction space for people to put their servers near the exchange server, so the speed of time between exchanges is reduced by that metric. And the number of trades that get offered in this thing is vastly greater than the number of trades that actually get done. So the volume of activity is orders of magnitude greater than the number of trades you would record as the actual volume. The reason I'm taking you into all this is to say that there is no one who can sit and watch those trades directly and apply anything to them. So what do we do? We build computer programs to extend our human skill, and we try to audit what's going on, but at the end of the day, the computers do the trading. Yes, there can be a dysfunctional aspect to that, but it's not as if people are setting things on their computers and then going to the Bahamas.

TR: So do you not think that the complexity of what the quants are building is a problem?

RM: There's no question it can have dysfunctional aspects. Anything we do can have a dysfunctional side effect. That doesn't mean that, net, it's not worth doing. Of course, when you have this speed of transactions and executions going on, there can be times, because they are driven by a computer, that if something happens that is not understood, the programs are going to end up continuing to try to trade, and that can affect markets. But that's not prima facie saying it's out of control--that these people don't know what they're doing, or that it was better before. Things used to get out of control without computers.

TR: So how do you think about technology generally, as it affects the functioning of markets?

RM: Well, first of all, it's very important to it. Second--and I say this a bit tongue in cheek--the people who are in the chip business ought to be very, very happy. If anyone worries about whether, with the advance of Moore's Law, we'll get to the point where computing is so excessively fast that we don't need anything faster: any time we think we get there, at least in the financial applications, all we have to do is add one more variable in our equations we want to solve, and you move yourself to the frontier of computing. But that's just an aside. Technology is a huge thing. If you look at the costs of transferring risk around the world, it's just remarkable what technology has done. That's the good side. The bad side is that things are much more complex and much faster. Does that say it's riskier than before? No.

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Tags

financial markets financial systems market complexity quants

Comments

  • market complexity?
    devassocx on 04/02/2008 at 1:30 AM
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    So this guy sliced and diced and tried to make
    sense out of a random system...and then it blew up.

    And now he is now teaching new generations of people how to do the same thing?

    I would say unbelievable.

    The current credit crisis is largely due to an investment community that leveraged dubious and overly complex investment vehicles using theories that are just wrong.

    The damage that has been done to economies around the world is obvious and devastating.

    Investment vehicles are not silicon chips.

    Its way past time to return to real values and not some grossly leveraged and imaginary FrankenEonomics techniques.
    Rate this comment: 12345
    • Re: market complexity?
      z0rr0 on 04/02/2008 at 10:55 AM
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      28
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      Transactional Capitalism - increase the volume of transactions, regardless of value, and attach a fee to each. The complexity assures that only a few will benefit... and they have, in great gobs.
      Rate this comment: 12345
  • [no subject]
    inboulder on 04/02/2008 at 7:09 PM
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    10
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    5/5
    "It wasn't about capability, it was about need. You can have all the technology in the world, you can have all the great models in the world, and if there isn't a perceived need, it doesn't get adapted."

    Um, shouldn't that be adopted?

    Also, I agree with the above, hedge fund managers lose to the s&p 500 80% of the time, the other 20% managed to get ahold of 'hot tips', but they all make themselves great wads of cash off the rake.
    Rate this comment: 12345
  • On Markets and Complexity
    jmaximus9 on 04/02/2008 at 9:52 PM
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    34
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    3/5
    The system is rigged in favor of the ringmasters, PT Barnum should have said there is a investor born every minute. The market needs a complete transformation. 
    Rate this comment: 12345
  • The Key Roles of Regulation and Sociopaths
    aheiber on 04/02/2008 at 11:30 PM
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    2
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    4/5
    This article points out the many ways, including innovation, that a deficiency in regulation can open up vulnerabilities to disaster. Capitalism runs on the rails of regulation. This is a Judeo-Christian culture and, thus, has an overburden of sociopaths, who are ever alert to opportunities to profit by doing harm to others.

    It is usual for economic models, expecially those promoted by conservative economists, to fail to include the potent role of sociopaths. Whenever there is an attempt at deregulation, such as savings and loans or energy, the sociopaths see and seize the opportunity with a result of costly harms. It doesn't matter whether the regulatory deficiency was purposely created by misguided believers in the regulation effects of competitive markets or by the lags of regulatory infrastructure in a changing environment. A sufficient excess of regulation is required to keep the sociopaths at bay.
    Rate this comment: 12345
  • Macro Economics
    denali1996 on 04/03/2008 at 4:44 PM
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    1
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    3/5
    This guy is talking about detailed intricacies of economic theory.  This is complex and interesting and way over 99.9% of the country.  The simple version is that unheralded economic prosperity drove many people to invest poorly in high risk ways...like buying houses that they can't afford with ARMs at interest rates at near historic lows (when they are at the bottom, they only go one way). This is not the fault of mortgage companies.  If someone told you that you qualified to jump off the Golden Gate Bridge, that doesn't mean you should.  Use some common sense.  Big surprise!...sometimes there is a Bull market and sometimes there is a Bear market.  Economics doesn't work without both.  Don't be mad at government because you made risky decisions.  Those people that realized 10 years of Bull markets was a little unusual are going to use the current "recession" to make a lot of money. Simply put: Investing works on the bigger idiot theory.  You can make a lot of money if you don't end up being the bigger idiot. If you do end up the bigger idiot, be smarter next time.  The Bull will be back.
    Rate this comment: 12345
  • model went bust
    stephan.froede on 09/22/2008 at 12:40 PM
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    4
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    1/5

    I just think their models went bust, the most expensive falsification in human history.

    The next step will be to create models that try to model the interaction of models on the market, multidimensional model interaction model or so...

    More RAM and CPU needed, buy Intel and IBM etc....
    Rate this comment: 12345
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