This is the text of an article in the Washington Post by Dominic Basulto about last week’s events in the financial markets. Great stuff.
When news first broke Thursday that JPMorgan’s credit derivatives portfolio had sustained a loss of $2 billion, and potentially as much as $5 billion, on trades gone awry, there was an immediate call for greater regulatory oversight over banks’ high-risk trading activities. The message was clear: “If you’re going to be a bank, then you can’t play at the casino,” as the Post’s Ezra Klein writes. At the same time that the market was lopping off billions of dollars in shareholder value, JPMorgan was purging top executives responsible for the bungled trades and facing awkward questions about its public stance in favor self-regulation. If banks can’t regulate themselves, though, who can?
Inevitably, the answer to that question depends on whether you view the financial markets as complicated or complex. If the financial markets are merely complicated, traditional approaches to regulation can be effective: regulators can turn their attention to individual actors within the market and systematically make the requisite changes to restore the market to equilibrium. In a complex system, however, traditional approaches to regulation can be woefully inadequate — small changes may end up having outsized effects, while big changes may end up having little or no effect. In a complex system, you need to focus on the interactions between each of the participants as much as the condition of individual actors.
The trading screens of Wall Street are, if nothing else, the perfect example of how computers are able to mask the complexity of an underlying system by being able to reduce the real world into 1’s and 0’s. There is no shortage of algorithms, formulas, sophisticated risk management models and quantitative trading models promising to reduce complex financial market interactions to something that can be studied, adjusted and tweaked. In theory, regulators should be able to look at a few numbers, compare them to a few benchmarks, and suggest the necessary adjustments.
But it is rarely that easy.
There is a big difference between complicated and complex. In a classic example, an automobile is complicated, but a transportation system with human drivers is complex. Ultimately, you can fix an automobile by lifting up the hood and checking that everything is working properly, no matter how sophisticated the parts. You can only fix a transportation system, though, by understanding how each of the drivers interacts with each other and understanding the distributions of dynamic traffic patterns.
One of the most innovative areas of public policy, in fact, involves the intersection of complexity theory with regulatory policy. Complexity theory, which has been used to model complex systems ranging from ant colonies to climate change, has also been applied to financial regulation. Practitioners within the financial markets are well-versed with complexity theory and its cousin: chaos theory. One of the entities consistently singled out in the academic literature is the CDC (Center for Disease Control), which is held up as a role model for how to deal with complex systems. For example, using complexity theory, the CDC was able to suggest that — contrary to what you might see in movies like “Contagion” — restricting air travel would have little or no impact on stopping the SARS outbreak. As the CDC recognizes, you simply can’t regulate away diseases. You need to deal with them with in real-time as they appear and find the right levers to stop them. Most importantly, you need to be able to spot potential flare-ups before they occur and understand the emergent behaviors that lead to outbreaks.
Certainly, the types of events that we observe in the financial markets, such as “flash crashes” and billion-dollar Black Swan events in derivative markets, are reminiscent of complex systems behaviors where small changes lead to unimaginable consequences. While the Volcker Rule, which would keep banks from engaging in risky trading behavior, could be effective in the short-term in avoiding certain types of adverse market effects, it may not be as effective in dealing with the full range of market fluctuations in the long-term. Implicitly, we recognize the complexity of financial markets by ceding power to computers and algorithms to price financial instruments properly. Now, we need to recognize that this complexity also has important consequences for the way that we think about regulating these markets.