When you have a hammer, all the world's a nail – network edition

I’ve read a few times the editorial by my former colleague Duncan Watts, and despite some interesting discussion, I can’t help thinking that this is a guy who knows a lot about networks and not so much about financial markets.

The article is about the problem of size and complexity in financial services organizations. Watts argues that we ought to pay attention to:

a general trend toward building ever larger and more complex networks. In recent years, hundreds of millions of people have rushed to join online social networks, while billions more rely on e-mail and cellphones to stay connected to friends and coworkers all day, every day. Technologists wax lyrical about “Metcalfe’s Law,” which posits that a network’s “value” increases in proportion to the square of the number of people or devices in it. And system designers revel in the ability of networks to improve a system’s overall efficiency by dynamically distributing computer-processing load, power generation, or financial risk, as the case may be.

And the answer is that we should prevent firms from becoming big and complex enough to be deemed “too big to fail.” For Watts, too big to fail is too complex to exist. Fair enough. But this is suggested in a complete absence of any content of what financial services firms, hedge funds, or other trading organizations actually do. For instance, are we speaking about proprietary trading positions in various markets that tie them together, like multi-strategy hedge funds (.pdf)? Or are we speaking about a firm that acts as a clearing member for a bunch of other firms, as it was the case in 2007 when the top 10 investment banks were counterparties to 90% of all credit market trades? Or are we speaking of firms that are/were wildly leveraged, like Bear Sterns (or its subsidiary, the magical Everquest Financial and its CDO-squared monster Parapet)?

In other words, Watts’ version of systemic risk only makes sense if we just put brackets around a disparate set of practices, encompassed in varied institutions, and call them all “a series of complex, interlocking contingencies.” Well, sure, a complex system of interlocking contingencies does indeed sound like it might create systemic risk. But it doesn’t say much else. And let me be clear that I’m on board with the problem of systemic risk. I just don’t know why it makes sense to think of financial markets as the same as email, and electric grid, or an epidemiological event.

So what instead? First, I think we need people with substantive knowledge of what financial services organizations do. This is not a way of saying that only finance people and economists should be figuring out what to do (these are the people, after all, who made this disaster), but it is a way of saying that abstract knowledge of risk or organizations or networks is insufficient. Securitization is not just an interlocking contingency – or rather, it is, but that’s saying almost nothing. The roots of that contingency, including the measurements of risk in the creation of new assets (as Yuval Millo would suggest) and the institutional and legal conventions of creating a limited liability trust incorporated in the Caribbean to launder asset-backed securities into invest-able shares (as I would suggest) are where the action is.

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