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the latest source of comment and analysis from the Institute for Security & Resilience Studies at UCL.


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

Dan Fox9 January 2012

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.



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.

Nondominium: establishing consensus and collaboration for the Caspian nations

Dan Fox4 October 2011

ISRS Senior Research Fellow, Chris Cook, argues that 21st century problems cannot be solved with 20thcentury solutions.

Wherever the writ of Western nations has run, so have attempts to impose the Rule of Law. But the Rule of Law has never sat well with other nations, particularly East of Suez, where absolute rights and obligations are not the norm, and where consensual agreements are customary. It is said that Napoleon’s experience in Egypt and interest in Islam may have informed the French Napoleonic Code.  In the context of civil law, French jurisprudence distinguishes between contrats de mandat, which are essentially one way agreements mandated by statute or judges, and contrats de société, which are associative, consensual agreements.

Similarly, the joke is that there are as many Sumo wrestlers in the US as there are attorneys in Japan. Anyone who has done business in Japan will know that because trust is assumed, agreements are typically simple and brief. And in Scotland there is, in addition to the existing polar opposite verdicts of Guilty and Not Guilty, a third null or indeterminate verdict of Not Proven.

There are two principal 20th century legal approaches to joint international development of resources:

  • International Law (Convention);
  • and Common Law (Equity).

(A good example of the Common Law approach is in the North Sea, where rights to production from oil and gas fields are now dealt with through the use of a common law ‘Master Deed‘ agreement.  While this is imperfect, it is a great improvement on the complete legal nightmare which preceded it).

There have also been proposals for ‘co-ownership’ between nations. But while Condominium – as it is known – is not unusual, such agreements have typically only been reached in respect of relatively low value bilateral territorial disputes.

Consensual agreement opens up a route to resolving even the most intractable disputes, such as those that arise over the most valuable territories.

The relatively simple – but still intractable – bilateral dispute between Iran and Russia over the Caspian Sea and its resources has, since the end of the USSR, been multiplied by the conflicting claims of what are now five Caspian-littoral nations (including Azerbaijan, Kazakhstan and Turkmenistan).  Their claims relate not just to rights on the surface, but to rights in the sea, and, above all, to the rights to what lies under it.

If a 21st century approach to territorial disputes can resolve this Mare’s Nest, then it can probably resolve anything.

A Caspian Partnership

The proposal is that the littoral Caspian nations should form a Caspian Foundation legal entity, and commit to that entity all existing rights in respect of the use, and the fruits of use (usufruct) of the Caspian Sea, and everything on it, in it or under it.  The Caspian Foundation would act as custodian or steward and the Caspian nations would have agreed governance rights of veto.

The Caspian Foundation agreement would reflect an agreement between the littoral nations jointly or collectively.

The negative or passive veto right of stewardship is very different from conventional property rights of absolute ownership and temporary use under Condominium. Moreover, it does not confer the active power of control held under common law by a Trustee on behalf of beneficiaries, and the legal complexities and management conflicts which go with that status.

The new term – Nondominium – reflects the fact that no country or combination of countries has the power of dominant control over the relevant territory and resources.

The Caspian Foundation would be a subscriber to a Caspian Partnership framework agreement between the nations; investors of money or money’s worth; and a consortium of service providers.

This Caspian Partnership would not be yet another international organisation, with everything that goes with that.  It would not own anything; employ anyone or contract with anyone: it would simply be an associative framework agreement within which Caspian nations self-organise to the common purpose of the sustainable development of the Caspian Sea. Within such a framework agreement a great deal is possible, although expectations may diverge to an extent that even consensual agreement is impossible.

The Caspian Partnership agreement would comprise a master framework agreement within which a myriad of associative agreements between the Caspian littoral nations individually or severally would be registered and evolve organically.

In particular, it is possible to envisage a new ‘pool’ of Caspian oil and gas production which would open up the 21st century direct financing and funding options of Unitisation (ie simply the issue and sale by producers of credits redeemable in payment for gas) which is the key market instrument underpinning the ISRS Resilient Markets initiative.

A Caspian Pool of natural gas production also opens up the possibility of a Caspian ‘balancing point’ spot gas price in just the same way as there is already a virtual national balancing point at which the UK spot natural gas price is set.


Many indigenous peoples, such as American Indians and Australian Aborigines, find it impossible to understand how anyone can own land.  Whereas most religious traditions – including Christianity, Islam, and Judaism – were all founded upon a belief that absolute ownership, particularly of land, is God’s alone, and that a tribute should be paid accordingly, such as a tithe.

It is apt to describe this proposal’s approach to the property relationship as Nondominium. Such a collaborative and consensual legal and financial framework for sustainable development and management of international resources is capable of revolutionising international economic relations.

The Irish Patient

Dan Fox10 June 2011

By Chris Cook, ISRS Senior Research Fellow.

ISRS’s first foray into my chosen field of ‘Resilient Markets’ was a jointly presented seminar which took place on 6th June before an eclectic audience,  including a former US central banker and a distinguished retired financier, but extending far beyond financial practitioners.

My co-host, Arthur Doohan, is a successful and radically innovative Irish banker. My background is of 25 years experience of market regulation and development, including six years as a director of a global energy exchange.

Our presentations, and the ensuing discussion, concerned two different approaches to resolution of unsustainable debt funding.  The current position in the aftermath of property bubbles in affected countries, such as the US, UK, Ireland,and Spain in particular, is analogous to the aftermath of a bad accident.

The English Patient has had his visible wounds patched up and these are now healed. But he continues – undiagnosed – to bleed internally, resulting in the need for regular transfusions of credit (Quantitative Easing – QE) by the Bank of England.  But at least – thanks to his QE – he’s walking about, albeit weakly and with dizzy spells.

The Irish Patient, on the other hand, was treated by doctors who stitched him up and then applied leeches, and is in a very bad way indeed.

Before even beginning to recover, the undiagnosed internal haemorrhaging of both patients must be stopped by Resolution of the debt:  only then can the patients’ recovery begin through a transition to a sustainable financial system.

Arthur and I take different, but complementary, approaches to treating the patients.

Quantitative Resolution  – Debt Offset

Arthur’s presentation covered his innovative proposal to galvanise the Resolution of Ireland’s disastrous and unsustainable legacy of property debt in the aftermath of what was perhaps the most egregious of all the national property bubbles.

In simple terms, he proposes to refinance and thereby resolve existing unsustainable debt.  He proposes new issues of debt at (say) 50% of the face value of the original, now unsustainable, loans which are secured against properties now worth 50% of their peak value.

The outcome is that the distressed borrower would have a dramatically reduced mortgage loan at a new (lower) rate, while the investors in the new loans exchanged for the old would own matching deposits on the other side of the bank’s balance sheet at the prevailing (lower) deposit rate.

Since the bank’s original distressed loan is currently priced in the market at 50% of its original value, this proposal recognises that unpleasant reality and builds Resolution upon it.

So Arthur’s debt offset mechanism offers a simple and elegant way in which Resolution of an unsustainable debt burden may be made by reducing the quantity of obligations.

Qualitative Resolution – Unitisation

My approach is based not upon debt created and issued by banks and secured against property, but upon the simple but radical concept of the issue by property owners of undated credits – ‘Units’ – redeemable in payment for affordable and index-linked property rentals.  Anyone who understands Air Miles, or Storecard points such as Tesco Clubcard points, will understand a Unit redeemable in payment for value.

Unitisation is, in effect, direct – ‘Peer to Peer’ – investment in property, with a return which derives from the market price of the Unit compared to the redemption value. eg a Unit with a face value of £1.00 issued at 80p offers a return of 25%,  but the rate over time of that return depends upon the date of redemption.

The enabling mechanism for Unitisation is the use of one of an emerging generation of legal ownership frameworks which are not conventionally based upon Company or Trust Law, but upon associative agreements and partnership-based vehicles.

Instead of a loan by a bank to a land-owner, which is ‘asset-backed’ by a mortgage claim, Units comprise a loan by investors direct to the land.  This ‘asset-based’ approach does not amend the quantity of obligations, but instead transforms the quality, so that the obligation to repay debt capital on specific dates disappears, along with compound interest.

This creates an interesting new calculus in respect of risk and reward.

Firstly, in terms of security, the risk for Unit investors in respect of their capital is not a credit risk – since their investment is not repayable on a specific date as debt is – but rather the risk that they cannot find a buyer:  i.e. a liquidity risk.  The risk that the Unit will not be honoured – through insufficient rental or otherwise – remains, however. Here it is the case that a rent set at an affordable level is, by definition, more likely to be paid; is thereby a lower risk; and therefore justifies a more modest rate of return.

Secondly, in terms of liquidity, instead of having numerous classes of debt fragmented by date, rate of interest and issuer; we have one single class of Unit in a rental pool created by multiple Unit issuers, with a  common custodian.  Moreover, if a financial investor is unwilling to buy Units, the price will fall to a level at which property occupiers will enter the market and buy Units for redemption.


There are certainly common elements to the proposals: there is the recognition that affordable payments are more likely to be made; and there is a similar symmetry between a right and an obligation, albeit Arthur’s model still has an intermediary bank between the two.

Where I principally differ from Arthur is in his view that the ‘London Model’ of property rights and investment is fundamentally a sound model. In my view, it is the London Model’s combination of compounding interest on debt, and absolute private property (particularly in land) which has led to periodic booms and busts for hundreds, if not  thousands, of years, and to the current systemic imbalance in wealth and purchasing power which is frustrating all conventional economic remedies.

I believe that through what is essentially an exchange of unsustainable debt for a new form of equity, we may  permanently resolve the existing funding problem, and prepare the way to a transition to a sustainable and resilient economy through a new approach to financing. But that, as they say, is another story, and for another seminar.