Two Book Reviews on Derivatives: George Soros and Satyajit Das

I just completed 2 books that touched on derivatives this weekend.

George Soros: The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means is a very interesting read.  His thesis on reflexivity is always fun.  I will comment on two core components of his thesis, but am not sure I appreciate them fully, so feel free to chime in with comments.

1. Falsifiability, in the Popperrian sense means by definition that economics is not a science, merely a pretender.  I would agree with this, due to the fact that human actors are participating, the rules are dynamic and reflexive.  Any system that responds not only to outward stimulus, but to its own perception of that stimulus and guesses in the future is inherently non-falsifiable as the presumption of "knowledge" precludes hypothesis.  It reminds me of my social anthropology training.
2. Derivatives are WMD (weapons of mass destruction).  I tend to agree with this quite a bit.  Derivatives themselves have long left the "hedging" risk transfer function and have evolved into gambling instruments.  As zero-sum instruments they aren't in themselves dangerous from a purely economic perspective. 
   I do believe however that from a risk concentration perspective failed netting in CDS could lead to a massive multi-bank failure.  The recursive nature of settlement failure in financial networks combined with CDS's sometimes fuzzy notion of EOD and settlements is a cause for concern.  Centralized effective netting is a start to resolution, but needs to be put in place faster than is currently happening. 
   These conditions when combined with the fact that many reference credits are over-written relative their value and may in fact be netting participants themselves is great cause for concern.  The financial system is a belief system and will face challenges in the light of a major netting counter-party failure. 
   Let's hope the appropriate central bank steps in as a back stop at the right time.  It worked for Bear Stearns (BSC) (a non-CDS) related issue, but that was a relatively minor problem.  The CDS concentrations of settlement risk is becoming less of a vague risk and more a statistical inevitability.

Satyajit Das: Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives, a funny and thankfully un-politically correct look at the world of bankers and derivatives, is an excellent view of the world through the eyes of someone with 25 years of experience, a keen wit, and a sharp pen.  The veneer that is put on the overly compensated, overly dressed and dangerously unaware participants in the OTC derivatives market is very refreshing. 

It is nice to have the pretensions dropped by an insider. Everyone is in it for the money and those with the most information win.  Customers are sheep for slaughter and traders use banks as either a veneer of legitimacy or the patina of patriarchal legitimacy.  At the end Mr. Das calls BS when he sees it, which is pretty nice and makes for an informative read. 

My only critique of the book is its audience level stretches too broadly.  At one point Variable Basis Points are discussed and in the next instance basic bond calculations are mentioned.  I think a good editor might have separated the specialist and the non-specialist bits.  The humour and trader anecdotes are very true to form and dealbreaker worthy. 

Comments

[Skjellifetti]

"Any system that responds not only to outward stimulus, but to its own perception of that stimulus and guesses in the future is inherently non-falsifiable as the presumption of "knowledge" precludes hypothesis."

Explain why this statement does not apply to quantum mechanics where the Heisenberg Uncertainty Principal shows that the very act of measuring something changes what is being measured. Your sentence sounds like Philosophy of Science buzzword BS to me. Have you been reading Nassim Taleb? If so, please stop. The man has only a superficial understanding of Popper and his rants become quickly annoying given that his own theories are inherently non-falsifiable.

[nick gogerty]

actually the "knowledge" here refers to Soro's concept of proven fact(s). Can't really elaborate on what it means in regards to Heisenberg. Uncertainty in closed domain is physicists business, I don't have any skills in that arena. I like Popper but can only say the "philosophy of science" is more anthropology than science. Science is an anthropic construct of facts arranged to define phenomenon. Without an interpretation system science is just information. any way probably to soft an issue to raise here as Seeking Alpha domain is for applied trading theory. I will post something applicable in the future in regards to trading falsifiability a la gott's theorem.

[Randall B.]

A agree with your reviews.

"Traders, Guns, and Money" was an excellent book to gain an understanding of expectations may be intentionally manipulated and how Robert Schiller's "Irrational Exuberance" may be caused. Dangerous are the unknown unknowns created by intentional opacity. Das continues to write very insightful articles.

George Soro's book was also insightful and I found his concept of "Reflexivity"... to be valid. Reflexivity, also addressed by another name in "Irrational Exuberance", must be addressed if rational expectations are to be formed. Also, his mini-autobiography was fascinating.

Here's one more to consider: "The Panic of 1907".

[Eva Smagacz]

I understand Soros' arguments for better use of the regulatory mechanisms to prevent market excesses as per Satyait Das. However, it is likely that the globalisation genie is out of the lamp for good and the banking, just like the other multinationals will simply diversify into other ways of making money by moving into countries with lesser regulatory regimes. I quite liked the idea that the new products cannot be issued unless and until the regulatory bodies understand them. Sort of FSA for banking.