Security specialists use a variety of ways to address the risks that they face: and these risk assessments are made in the certain knowledge that the actors in the system hold only incomplete information. Although much mocked at the time, Donald Rumsfeld’s categorization of “known unknowns” and “unknown unknowns”, is now generally recognized as a succinct summery of his strategic quandaries.
By contrast, actors in the financial markets have a more sanguine assessment of the risks they deal with: they divide them into two kinds of risk: quantifiable and unquantifiable. Unquantifiable risk is not generally considered, since there is usually no financial profit that can be made except from pure supposition. Therefore for the purposes of the financial markets, any given event is priced relative to its level of probability, that is to say its quantifiable risk.
Depending on the market, higher levels of risk generally carry higher prices, lower levels generally lower prices. Clearly such an assessment of risk may not be objective, so markets have evolved a “psychological” approach to price discovery. Nevertheless, in the course of the twentieth century a detailed mathematical analysis has been developed, first in the credit market- what you owe- and later in the equity markets- what you own. In assessing risk, market actors use statistical models both to assess the internal functioning of the market and also to examine the external context of the market. Bell-curve based models have offered a relatively simple way to understand the process of price discovery and the impact of rare or highly improbable events are usually less considered, because in the majority of cases a large sigma divergence from the market mean is a low risk event.
Yet low risk events as defined by statistics may still have drastic impacts, and it is becoming clear that the financial markets have been fundamentally mispricing risk for a prolonged period of time. Put simply, conventional financial risk models seem to work in normal market conditions, but they lose strength in extreme conditions. Essentially this means that conventional risk models have failed, and that persistent failure has been compounded by regulatory collusion to create the probability of even more unstable conditions in the future. The prolonged policy of global low interest rates that was adopted to deal with the credit crisis of 2008 has continued despite a growing appreciation that it is multiplying risks in ways that are poorly understood and which has the potential to return financial markets to a period of even greater instability. The risks in the global financial markets have real world consequences, and there is now a growing sense that the global financial markets have emerging problems that could have significant economic and geo-strategic impacts.
The impact of highly improbable events, memorably described by Nassim Nicolas Taleb in his books “Fooled by Randomness-the Scandal of Prediction” and “The Black Swan”, is still not fully recognized. By definition six Sigma market events are rare and given the average age of market practitioners, there are not many traders who have experienced the drastic crisis moves associated with a “Black Swan” event. Yet, as Taleb argues, the once in a lifetime events that statistics predicts, in fact occur with far greater frequency: roughly once a decade. This of itself implies that the statistical models that lie at the heart of the modern financial trading system are built on a predictive model that consistently misprices risk assets. The models purport to be an objective measure of risk, but in fact they are based on a closed model system, which implies finite and knowable inputs into the process of price discovery. In fact markets are fractal in nature, and therefore the risk model should, by definition, be an open ended system. It turns out that predicting the future in financial markets, as with anything else in life, cannot be relied upon, and the most successful traders are those who react to risk, rather than those who rely on predictive models, no matter how sophisticated. Long Term Capital Management collapsed despite the fact (Taleb would say “because of”) the company having several Nobel Laureates in Economics, who built extremely sophisticated predictive risk models. George Soros, by contrast, relies on a structured form of psychological analysis (“Reflexivity”) which is more open ended, and despite many failures, he is still in business.
In addition to the issues of risk taking, there is the matter of risk recording. The extreme complexity of the instruments that are being circulated has led to considerable debate about if, when and how profits from these booked trades should be recorded. In some cases, famously on some structured derivate trades between AIG and GS, it has transpired that both sides of the trade were booking profits- a literal impossibility in the zero-sum world of financial instruments. The audit companies were complicit in the mispricing of trades, and given the essential oligopoly of the “Big-four” auditors, the market failure the risk of mis-recording the results of trades in complex financial instruments remains unaddressed.
In the face of the fundamental market failure that was revealed in 2008, the regulators also have to shoulder their share of the blame. The fact is that they too do not seem to recognise the open ended nature of risk, and as a result continue to believe that greater capital resources are the primary means to avoid significant weakness in the financial markets. In fact what has happened is that the requirement for larger capital resources means a greater concentration of risk in reduced number of market players. Market players that are deemed “too big to fail” create greater moral hazard in the longer term. The extraordinary blizzard of regulation that was created following the 2007/8 credit crunch had several goals in mind, but the ultimate effect has been to create a more rigid process in risk taking and a larger capital requirement to enter the market. The ring fencing of bank deposits has grown stronger, and there has been some tinkering with the permissible assets that may be held on bank balance sheets. However, the major impact of the 2008 crisis has been the assumption by monetary authorities, and by extension the taxpayers, of a gigantic liquidity pool. The full faith and credit of finance ministries and monetary authorities is still being used to underwrite liquidity in the market, even at negative interest rates. Effectively the global regulators flooded the market with “good” money in order to replace the problematic credits with "undoubted" government money.
A decade later, market conditions have still not returned to historic norms. Since its foundation in 1694, the average Bank of England base rate has been around 5%. Even with a recent rise, the current rate is 0.75%- a long way off historical norms. This pattern is repeated across the global financial markets. Policymakers are now in a bind: they are still nursing banking systems that have been deeply damaged by the long credit boom which ended in 2008, but are aware that they must sooner or later raise rates before the adjustment to higher rates becomes disruptive.
Since 2008 global financial markets have continued to grow, and this is not solely the result of the liquidity bonus injected by the market regulators. After 2008, as much as before, there has been a major shift in the global economy which has unleashed a spectacular level of global growth. The emergence of China allowed a massive increase in efficiency in global supply chains, as huge Chinese corporations became globally competitive and were able to offer goods that met global market expectations. The globalization of production has had a drastic impact on economies throughout the world, and although there have unquestionably been losers, the net result has been an extraordinary productivity gain. Nor has globalization been purely a matter of substituting cheaper Chinese production for more expensive production elsewhere: there has been a general maturing of economies across Asia, America and Europe as innovation centres emerged and service businesses replaced manufacturing. Even in China, the service sector has grown dramatically, and lower value production has been off-shored to even lower cost manufacturing centres, such as Vietnam or Bangladesh. Among economists, there is little doubt that the massive increase in wealth that has resulted from the emergence of more globalised economies has been an unalloyed good. Thus financial markets have been operating in extremely favourable macro-economic conditions.
However there are several threats to this long-term virtuous economic circle. Firstly there is the question of sustainability. The ecological damage of unrestrained production is now unquestioned, and it is clear that Earth does not have the resources to maintain unsustainable economic growth. The human population spike- with our species likely to peak somewhere between 9-11 billion individuals within the next century- will require much greater efficiency in order to allow the planet to absorb the population shock. As CO2 pollution becomes a greater worry, there is a growing risk that delicate ecological systems are already breaking down, and reducing still further the ability of the planet to sustain such a large human population. The economic effects of these extremely complex processes are unknowable, but it certainly is clear that there is greater uncertainty about the sustainability of –for example- food production than at any time since the “green revolution” of the 1960s and 1970s.
Equally there are more immediate macro-economic threats. The first is the nature of innovation. The mid-twentieth century saw huge changes in, for example, transport and communications speeds. It was only 66 years form the Wright Brothers making the first controlled powered flight to the first flight of the Boeing 747 and indeed the first landing on the Moon. In the nearly fifty years since 1969 the speed of transport has not increased- indeed with the withdrawal of the supersonic Concordes in 2003, commercial faster than sound flights no longer exist. Yet the expansion in use of commercial jet liners has increased drastically. Likewise the speed of a telephone call has not increased much since the creation of a global telephone network, but the use and density of the network now allows the exchange of colossal amounts of information, especially through mobile systems. If the Olympics represents “faster-higher-stronger”, global digital technology is simply broader on a scale that was never forecast at its inception. The question, from an investment perspective, is how to maximise the payback period for any given innovation. This proves easier to manage with digital businesses than physical goods. Innovation delivery that can be made by a simple download of information is likely to be far more profitable than the modernisation of physical goods. Market changes can severely impact huge investment programmes: a good example is the Airbus A380, a plane widely touted to be the replacement to the hugely successful Boeing 747, but which has struggled to find sales, despite its extraordinary technological prowess. The innovation of lighter and faster twin jets has made the A380s economics quite problematic in the current market conditions. It is far easier to make structural changes to information systems than to a physical piece of equipment. So, although we say that the twenty-first century is a period of spectacular innovation, it is innovation of a very specific kind, of information processing rather than physical processing. Of course this may change, with the creation of widespread 3D printing, for example, but equally there are risks in the digital world too. Following a series of scandals, the value of Facebook has fluctuated quite wildly. It turns out that consumer taste is still the prime driver of value in services- and consumers can be fickle.
The wave of information innovation has disrupted and challenged human activity across the board. Even the idea of “money” has not been immune. The so-called “crypto” currencies have challenged conventional views about what cash actually is. Although Bitcoin looks like a bubble, and despite the hostile stance of major investment houses- such as JP Morgan- the crypto boom has changed but it has not gone. The usefulness of what Goldman Sachs has labelled “consensus” currencies (as opposed to fiat currencies) remains untested, but is still being explored and the emergent ICO market has the potential to supply an asset base to support a fundamental value for such currencies. The value of consensus currencies will probably mean that in the long term they will form a larger part of the global financial markets- and one that is beyond the control of current market regulations.
Ten years after the great crash, the risks in the Financial Markets are as high as ever. It looks like being an uncomfortable Autumn.