Rethinking Markets

There was a time when capital, financial, housing markets were distinct-but-related. Housing prices changed with changes in interest rates; the dot-com boom and bust created and lost jobs; the stock and bond markets moved in conjunction with these changes. But while related, they were pretty much distinct kinds of markets. This was true for a few reasons.

First, different people traded different markets. Equity desks (stocks) and futures traders (fixed income) were different people, with different skill sets necessary to actually trade these markets. Mergers and acquisitions departments were deal-makers; private wealth desks were relationship managers; futures traders were cowboys; municipal bond traders were plodders.

Second, different technologies of trading made these markets comparable via performance (that is, returns on investment) but not otherwise comparable. In other words, we could look at stocks, bonds, and real estate, and we could measure their Returns on Investment (ROI) over time. But the question of how much a real estate investment was worth relative to an investment in corporate bonds, relative to fixed income derivatives, all while capital is being applied to them? This question is a notoriously difficult one to answer.

And so, the world looked something like this:

Distinct markets, distinct participants, distinct technologies

This changes with two things: risk models, and technology

• The application of risk models to financial instruments. It is not just that Black-Scholes-Merton formula allows us to price options. It allowed sophisticated analyses of returns, captured by risk and volatility. Risk is the magic commensuration mechanism. Commensuration here means a metric (often, but not necessarily quantitative) that allows us to compare two otherwise qualitatively distinct objects. Understanding returns as a function of risk and volatility (assumptions and measures about transaction costs, liquidity, and the like can be incorporated as well) means that real estate, bonds, stocks, derivatives, collateralized debt obligations, fine art, even your Uncle Earl’s gold coin collection can all be translated into a common metric: how much risk, how much volatility, equals how much return?

  Risk becomes something that can itself be traded. When portfolio managers argue that a portfolio ‘needs more vol’, for example, it means that it needs more ‘risk’. Risk is being commoditized.

• Changes in technology. Ian Domowitz, then a finance professor at Northwestern University, noted in the early 1990s that one of the main effects of automated trading would be to provide a degree of standardization across a number of financial exchanges. This standardization would lead to mergers (implicit) across exchanges. These exchanges had, for the better part of the last century, been not only distinct but direct rivals. Their rivalry was resolved less by poaching contracts from one another, and more by specialization. So oil and OJ was traded in New York, currencies at the Mercantile Exchange, soybeans and Treasury futures at the Chicago Board of Trade. The ability to now trade across exchanges, or better, to have a technology that allows you to have different “back end” trading systems and a single “front end” platform. Think about it like a web browser. The back-end servers may run Unix, windows, OSX, Ubuntu, or whatever. The front-end web browser makes them all work for any user. Likewise, front-end electronic systems allow traders to actually make trades across a wide variety of financial (and non-financial) products.

So now the world looks less like a set of distinct silos and more like this:

The world looks like silos, but it is all just Risk

As a result of this fact – this fact of the contemporary world of risk management and globalized finance – a number of assumptions that we had previously held to be true no longer are. For example, arguably commercial banks, insurance companies, and investment banks are indeed all doing the same thing: they are all trading in risk. The ways they do this continue to differ, but the underlying ways that they can calculate their worlds have moved closer. This means, per someone like Robert C. Merton (and people who believe in him in the Treasury Department and in Congress), that we should allow the institutional barriers between these kinds of firms fall to follow their functions. Or, it means that the old regulations that separated these entities institutionally need to be revised to provide protections in a world where they are all doing the same thing. This is obviously now an open question.

A second assumption, that financial ‘safety’ comes in offsetting risks across a number of uncorrelated markets – diversification – no longer means what it used to mean. If the silos no longer hold, the problem is that ‘uncorrelated’ risks become correlated in the very act of tying them back into a risk portfolio. What we see instead is not ‘uncorrelated’ risk – barriers across different kinds of markets – but rather conduit of risk across these markets. Diversification becomes contagion. Why does the stock market drop 700 points when people are worried about credit markets? In no small part because hedge funds are bracing for mass extractions of capital. And so they are dumping their most liquid investments to have cash on hand. Credit and equities are supposed to be distinct – and now they are moving together. Risk becomes the conduit through which markets become linked.

We’re bracing for a new world, and it is unclear to me that the institutional changes that have been brewing over the past three decades are well-understood. New approaches would be mighty useful right now, and more so going forward.