Mapping the Market Genome

I was invited to speak on Friday at the XBRL Risk Governance Forum (.pdf), hosted by the IBM Data Governance Council. Having said that, most everyone is going to be tempted to yawn and stop reading further. Don’t. Within the work of this Forum are the seeds of reducing the risk of future market crisis. Indeed, it could be the foundation for a quantum leap in risk management.

To explain why, let me start by going through the dynamics of market crises. A market crisis occurs when there are highly leveraged investors in a market that is under stress. These investors are forced to sell to meet their margin requirements. Their selling drops prices further – especially because the market was under stress to begin with. So you get a cascade down in the price of that market. A shock that might have initially led to only a five percent drop gets amplified, and the market might drop multiples of that. We have seen this in various guises in the current crisis, from the banks' 'toxic waste', to the downward spiral in housing prices, to the deleveraging of the carry trade, to the quant fund crisis in August 2007.

And the dynamic gets worse. Many of those under pressure to liquidate will discover they no longer can sell in the market that is under stress. If they can’t sell what they want to sell, they sell whatever else they can. So now they move to a second market where they have exposure and start selling there. If many of those who are in the first market also are in the second one, and if the investors in that market are also leveraged, then we see the contagion occur.

Here are two examples of what I am talking about.

Example one is LTCM. The proximate cause of LTCM’s demise was the Russian default in August, 1998. But LTCM was not highly exposed to Russia. A reasonable risk manager, aware of the Russian risks, might not have viewed it as critical to the firm. So how did it hurt them? It hurt them because many of those who did have high leverage in Russia also had positions in other markets where LTCM was leveraged. When the Russian debt markets failed and these investors had to come up with capital, they looked around and sold their positions in, among other things, Danish mortgage bonds. So the Danish mortgage bond market went into a tail spin, and because LTCM was big in that market, it took LTCM with it.

Example two is what happened with the Hunt silver bubble. When the bubble burst in 1980, guess what market ended up being correlated almost one-to-one with silver. Cattle. Why? Because the Hunts had to come up with margin for their silver positions, and they happened to have large holdings of cattle that they could liquidate.

Could we have ever anticipated beforehand that we would see a huge, correlated drop in both Russian MinFins and Danish Mortgage bonds? Or in silver and cattle? There is no way these dynamics can be uncovered with conventional, historically based VaR type of analysis. The historical return data do not tell us much if anything about leverage, crowding and linkages based on position holdings.

This is not to say VaR is not of value. I think everyone who is involved in risk management understands the limitations of VaR, what it can and cannot do. It is sometimes put up as a straw man because it is not doing things it was not designed to do, things it cannot do, such as assess these sorts of liquidity crisis events and the resulting cascade of correlations that result.

But the proper use of mark up languages along the lines of XBRL can give us the data we need to address market crises as they start to form. What we must do is have a regulator that extracts the relevant data – in this case position and leverage data – from major investment entities. These would include, as a start, the large banks and largest hedge funds. With assurances of data security – the data would not be revealed beyond the regulator – a government risk manager would then be able to know what currently cannot be known: where is there crowding in the markets, where are there ‘hot spots’ of high leverage, what linkages exist in the event of a crisis based on the positions these investors hold?

For these reasons, the first recommendation in both my Senate (.pdf) and House (.pdf) testimony was “get the data”. How can we do that? Well, first, by legislative demands to require investment firms -- including large hedge funds -- to provide the data. Then by the proper application of a mark up language so it can be done in a consistent, aggregatable way.

To give an analogy for this, one that came out in the conference and that illustrates how far behind we are in financial markets, a mark up language for risk would do for the financial products what bar codes already do for real products. If we discover a problem with peanuts being processed in some factory, we can use the bar codes to know where each product containing those peanuts is in the supply chain, all the way down to the grocery store shelf.

Having the proper tags – the proper bar code, if you will – for financial products, ranging from bonds and equities to structured products and swaps will allow us to understand the potential for crisis events and system risk. It will help us anticipate the course of a systemic shock. It will identify cases where many investors might be acting prudently, but where their aggregate positions lead to a level of risk which they on their own cannot see.

It also will give us the means to evaluate crises after the fact. Just as the NTSB can use the black box information to help improve the airline industry by evaluating the causes of a airline accident, this position and leverage data will act as the black box data to help us understand how a crisis started, and, coupled with interviews of the key participants, help us understand what we need to do to improve the safety of the markets.

Comments

[jaycey:]

That's kind of like saying what we need to handle global warming is more efficient air conditioners.

You can have the best information, the most high tech war-room-command center, but it won't mean much.

We have a world awash in too much debt caused by massive trade imbalances. We have a regulatory system that's dysfunctional not because of incompetent regulators but because of venal politicians and their paymasters the financial oligarchs. We have an underconsumption problem because workers are not getting paid enough to purchase the fruits of their labor (hmmm, when have we seen that before....).

This meltdown is a symptom of a deeper rot in our system and you can have the fanciest fire trucks in the world, but as soon as you put out one fire, another will start somewhere else. They won't end until we rebalance trade, give the workers of the world a raise (here and in the Asian surplus nations), shrink the financial industry by half or more, and throw the incumbents and their lobbyist pimps out of DC.

VAR, Schmarr, guns don't kill people, *people* kill people.

Mar 03 03:48 AM

[Nikola:]

"We have a regulatory system that's dysfunctional not because of incompetent regulators..."

Sorry I beg to disagree. I think our regulators are incompetent.

And that's the problem with this XBRL idea. Data is there folks as is. We have the computing power to analyze it. The Web is bigger than Edgar, and yet Google keeps it under wraps. The issue is that once in a while you get an administration that tells regulators to back off so they can plunder the market. And ain't no XBRL that's gonna fix that.

There is a variation of this idea in a recent Wired article that might stand a better chance because it involves the public, not because it involves XBRL: www.wired.com/techbiz/...

Mar 03 04:49 AM

[morph366:]

I agree with the preceding comments and find that the author seems to suffer from a common misapprehension about market risk. Academic finance has failed to uncover the reasons why liquidity crises gain momentum and why asset correlations exhibit very different characteristics under "normal" market conditions and then jump to far more extreme levels during periods when financial contagion takes over.
Collecting more data - even assuming that the big financial players will not have devised even newer ways to circumvent transparent disclosure (e.g. algorithmic trading etc.) will just expose even more the poverty of the data modeling and analysis techniques.
The real challenge is to have a wide-reaching and open debate about the consequences of inevitable failures in risk management - who pays for the clean up? - who is accountable at the firm level? - the system level? - how do we deal with the shadow financial system which largely operates in tax havens? - how do we deal with jurisdictional arbitrage? Not necessarily issues that those versed in financial engineering are well equipped to answer - they require input from experts in other disciplines with broader backgrounds in ethics, cultural history, and behavioral economics.

Mar 03 05:47 AM

[Boaz Berkowitz:]

Excellent article!

Mar 03 07:30 AM

[Geoffrey Mo...:]

XBRL and "crowdsourcing' (Wired's suggestion) are both part of the solution.

The key step is to realize that the stock market is a complex adaptive system - one that has the capability to learn in its parts and as a whole - and can never be managed top down and from the center. All the TARP and Stimulus interventions are likely to do is provoke unintended and mostly unwelcome consequences.

One way or another, it's the people at the grassroots who will be left to pick up the pieces. Everything we do to improve dialogue, like XBRL and radical transparency, will help them to self-organize and thus encourage the emergence of the local solutions which will eventually crystallize into the global behaviors that will be the only things that can accelerate the recovery.

Mar 03 07:59 AM

[Speedspirit:]

To Richard,

Please understand that your very optomistic point of view just doesnt take into account the corruption, deceit and manipulation of the system. When the crooks are mixed in with the solution they sneek in loop holes and variations of laws to allow themselves advantages. So yes you can dream of tightening the rules and laws and hold poeple accountable but look at this crisis look at the evidence of outright deciet and lies. And now we just hand them more and more money. When things get bad enough they will buy with the "new" money they recieved the mortgages and rewite them and with terms of making money off them. Again they make more money. So lets recap, they created the first bubble, cryed wolf, got more money, are creating a new bubble make more money and will leave the American people and the world in a complete meltdown. But dont worry eventually they will feel such remorse they will give all the money back so we can try to start over because they learned the errors of thier ways.NOT! The system that works well for bankers, lobbyist, insurance companies, hedge funds only provide for say 10 % of the nation and if the rest of the nation isnt provided for thats just not fair. The time is right to admit the system is out of balance and now its time to create true balance. Sure the 10% ers will cry but its the right thing to do. Please take that thought with you to your meeting friday. Whats the right thing to do!

Mar 03 08:14 AM

[huangjin:]

You can't trust regulators. They are corruptable. Just wait until we learn that so and so has been paying regulators to leak information. Even if you start with a good system, over time it will break down and fail.

What's needed is transparency. Let the public know what positions are highly correlated in hedge fund and institutional portfolios. The longs and shorts will naturally attack any exposed weakness, and they will serve to self-regulate the system. Of course, then we'll have a new set of problems...but probably smaller than before.

Mar 03 08:43 AM

[Lilguy:]

So what you're saying is what Buffett said in his annual report about counterparty risk: It's not just who you sleep with, but who they're sleeping with that creates risk. .

But it's not just about counterparty risk, it has a lot to do with Taleb's "black swans," the unknown and unknowable unknowns that can crash any risk model however "sophisticated."

Mar 03 10:07 AM

[joelandsonia:]

Actually, I like the idea, but only if the gathered data is open to all. Some very interesting applications might come of it, not only better monitoring tools both by the government, but more importantly outside resources on the lookout for fraud or skewed positions.

Mar 03 11:53 AM

[Simon Smelt:]

More and better quality information helps.
But,
- it doesn't change people (and one doesn't have to assume corrupt regulators, just the usual mix of laziness, incompetence, poor governance and perverse incentives)
- it doesn't change the big drivers - too much cheap debt etc.
- it doesn't change the situation we're in
- it could make matters worse if looked on as a magic fix (too early for that - wait 10 years).

Mar 04 01:56 PM

[Richard Boo...:]

A belated reply to these comments.

Data will not take care of everything. But it is a logical first step. Logical because it can give us more information to understand what dynamics are important. And logical because, at least in my current view, it would not be costly or intrusive.

If the data are not well analyzed, or if the analysis is good but there is no follow-through by the government to take action, then the efforts still might not be successful. I am arguing to take the first step, and see where things then sit. I take it as a given that even if this first step is well executed, regulation could fail.

Mar 23 09:57 AM