“We can stack odds in our favour on risky events”

ISRS Director of Programmes, Dr Jamie MacIntosh, and Paul Ormerod of Volterra Consulting, had a joint letter published in the Financial Times last week. They wrote to detail the FuturICT project, in response to an article of 30 December, by Gillian Tett, highlighting the threats still posed by phenomenon such as May 2010’s “Flash Crash”, and calling for a “wind tunnel” to test financial innovations such as High Frequency Trading.

The letter is available on the FT”s website (free registration may be necessary). A fuller exposition of the ideas is below.

 

HEALTHY INNOVATION: THE RACE TO LEARN

As Gillian Tett points out (30th Dec, Flash Crash threatens to return with a vengeance), a “wind tunnel” for evaluating financial innovations would be “pretty sensible”. Whilst the US Office of Financial Research (OFR) is “floundering”, the EU need not wait. In addition to the UK Government’s Large-Scale Complex Information Technology Systems project, a consortium of world-class researchers from across Europe is among six finalists for a €1-billion research grant from the European Commission’s Future and Emerging Technologies programme. The FuturICT project has already assembled the research network necessary to build the financial innovation “wind tunnel”. It offers a capacity to explore the healthiness of innovations for the world economy – not just the financial sector or one state.

A key lesson from the first phase of the financial crisis is that regulators were far too slow to absorb crucial advances in scientific knowledge. As early 2000, two major findings had been established beyond doubt. Firstly, the distributions of asset price changes did not adhere to a normal distribution. They had fat tails. Extreme price movements were rare, but many orders of magnitude more likely than if price changes really were normally distributed. Secondly, the risk diversification claimed for many portfolios was a delusion.

Despite these findings, established in scores if not hundreds of scientific papers, regulators remained wedded to the classical Value at Risk and capital asset pricing models. In ideal times, these may be adequate approximations of reality. In reality, made evident during challenging times, they give dangerously misleading information.

Regulators once again are at risk of failing to keep pace with technological and scientific advances. The on-going crises have not stopped financial innovation. Just like the innovations in Credit Default Swaps (CDS) that did so much to fuel the economic crises from 2007 onwards, the High Frequency Trading  innovations at the heart of May 2010’s “Flash Crash” may be healthy or unhealthy. It is too hard to tell using conventional approaches.

FuturICT is a pan-European project that integrates natural sciences, technology and social sciences. It does so by harnessing complexity science. This not only enables multiple disciplines to integrate but also does so where it matters most to us today: improving our understanding of risk and uncertainty in networks.

This is as much about preventing unhealthy regulation as unhealthy innovation that defies regulation. To achieve such an outcome, the FuturICT financial innovation “wind tunnel” will learn the lessons of financial sector circularity, which was masked as risk diversification. Instead, the measure of healthy innovation will be grounded in what it does for the real economy.

FuturICT is not another sounding box for despair among doom-mongers. Nonetheless, it is realistic about human behaviour. The basic toolkit of the consortium is not the isolated rational agent of economic theory, but networks. An appreciation of the connected nature of the world economy, and especially of the financial sector, was sadly lacking in the regulatory and policy worlds in the period leading up to the crash. To understand the world today, we simply must understand networks.  What the structure of connections is, how it is evolving, and who influences whom.

Advanced modelling is also able to anticipate the formation of hubs, through which activities become either harmful or healthy “superspreaders”. Where “too-big-to-fail” and “too-connected-to-fail” may be obvious, other hubs in networks are not so. Learning the lessons of the last war can be counter-productive. So, for example, in well-regulated mature financial centres innovative use of High Frequency Trading (HFT) may be healthy enough (it may even offer a way to smooth Repo Markets) but HFT can spawn trading platforms anywhere. Detecting when or if these became unhealthy superspreader could be vital to the world economy.

We should, of course, be cautious about predicting events in our complex world. But there is no reason why we cannot stack the odds more in favour of winning the race to learn rather than being overtaken by events. Access to data, evolutionary modelling and participation in use of both models and data are all accelerating the potential for healthy innovation. The race to learn is not only realistic but an imperative. Finance has its innovative part to play. Finance, jobs and competitiveness can be brought into strong accord, based on the one real competitive advantage a developed economy has: knowledge workers.