Happier New Predictions from wordup!

We're all brimming with predictions about 2010 at this time of year. We know that a year is a long time in politics, yet for some reason there is a collective over confidence, peaking in the New Year, that we have a handle on the most important events that will take place in the next 12 months.

I'd like to lead a retreat from over extended predictions and it seems I am in good company. With Japan.

Japan's official weather agency has ceased making its traditional prediction about the start of the cherry-blossom season. "The agency has given out such information in early March every year but we will no longer do so from next year," said agency official Yoshitoshi Sakai. I also salute their courtesy for providing almost 3 months notice of the policy change.

This is a serious issue for me. Not the start of the blossom season, although a precise prediction is great for making advance travel arrangements to see Japan in bloom.

Good models help us peer through the fog of observation and reveal the best interpretation of what is going on. We like to know what the future will bring, but dislike the fact that some of it is fundamentally unknowable to us.

Consider that a good visionary may not be someone claiming to see furthest, but rather someone that sees the 'here and now' differently. Arguably, it is from this that we might learn the most.

Happy New Year!

Online collaboration in finance

Is it likely that the finance industry will embrace social media? I found myself back at the Centre for Global Dialogue this week to hear what banks and insurance companies really think about enabling employees, as well as a firm’s extended client community, to interact and share information using corporate online platforms.

First of all, there seems to be a lot of interest in corporate social media. Many separate motivations appear to explain this interest ranging from recruitment, to product marketing, to the simple goal of answering employees’ wishes.

Social media might also be a way to access tacit knowledge within a company. Under the right conditions, a social media platform could record valuable exchanges between employees that might otherwise never leave the water cooler.

There lies the rub.

Under the wrong conditions, the risk with corporate social media is that it functions as an all-watching big brother. Who would want to collaborate online if there were ambiguities about how the information was used and no protection of privacy?

A presentation by Marilyn Pratt was informative in this regard. Pratt co-runs a corporate social media initiative at business systems software firm SAP involving almost 2 million people. Posts appearing on the platform are moderated, but that doesn’t mean that a group of company spooks go around erasing anything that hints at criticism of the firm.

Indeed, even the really irritable posts go online in a section called the ‘Coffee Corner’. As for the moderation process, 700 of the moderators have been recruited from outside SAP. These and other comments from her presentation suggested a sophisticated online culture has developed.

 

So there are certainly some conditions where a corporate platform can work in practical terms. Reading a little into this area I recently came across a book called ‘Delete: The virtue of forgetting in the digital age’ by public policy academic Viktor Mayer-Shoenberger.

Based in Singapore’s Lee Kuan Yew School of Public Policy, Mayer-Shoenberger believes that even the most sophisticated attempts at corporate best practice will fall short protecting your digital privacy. Ultimately, he argues, the solution is to place a limit on the duration that digital information is stored.

To delete periodically.

I have plenty more to report about the conference, but that might have to wait for subsequent posts.

Financial regulation and the ecological niche

A crazy thought experiment: what happens if I take a science research paper and substitute the topic of investigation with a hot topic from the social sciences: financial regulation?

Below, I have included excerpts from the original science paper and from my newly minted thought experiment 'paper'.

Original title: The importance of niches for the maintenance of species diversity
Thought experiment: The importance of Glass-Steagall legislation towards inhibiting risky levels of concentration among financial intermediaries

Original introduction: Ecological communities characteristically contain a wide diversity of species with important functional, economic and aesthetic value. Ecologists have long questioned how this diversity is maintained.
Thought experiment: Recent events in global financial markets underscore the risks of excessive concentration among financial intermediaries. Sometimes referred as the problem of 'too big to fail', economists are seeking ways to prevent financial systems from being populated by a small number of dominant players.

Original introduction: Classic theory shows that stable coexistence requires competitors to differ in their niches.
Thought experiment: A canonical lesson of the Great Depression was the recognition of the need to separate the granting of credit — lending — and the use of credit — investing. Specifically, the Glass-Steagall act of 1933 enforced a separation between commercial banks and investment banks.

Original introduction: That niche differences are key to coexistence, however, has recently been challenged by the neutral theory of biodiversity, which explains coexistence with the equivalence of competitors.
Thought experiment: With the repeal of the Glass-Steagall act in 1999, financial theorists convinced regulators that stable financial systems could exist even when a bank has the choice to participate in commercial as well as investment banking activities.

Now, let's get a little stranger. Let's look at results and conclusions of the two papers:

Original findings: However, in the absence of niche differences the most common species, Salvia columbariae, became considerably more common, constituting almost 60% of 2008 community seed mass.
Thought experiment: In the absence of the Glass-Steagall act, Citigroup constituted almost 60% of 2008 global financial market.
Conversely, the seven smallest regional banks constituted 35% of the financial markets in the presence of Glass-Steagall Act, but only 8% in its absence.

Original conclusions: Our results support the hypothesis that niche differences strongly stabilize coexistence.
Thought experiment: Our results show that a separation of investment and commercial banks produces a marked reduction in dangerous concentration in the financial sector.

I'll stop there. The original paper, by Levine & Janneke HilleRisLambers, appears in the September 10th edition of the journal Nature.

Swiss Doctoral Workshop in Finance, Darrell Duffie and SoFiE

wordup will be on the road next week beginning Monday with a visit to the Swiss Doctoral Workshop in Finance, held near Bern. I will then move on to Geneva for a presentation by Darrell Duffie before joining the opening of the second Society for Financial Econometrics conference, also in Geneva.

The Doctoral Workshop (image, left) assembles graduate students from top finance research schools throughout Switzerland and places them before an academic audience from around the world. The venue, Study Center Gerzensee, is run by the Swiss National Bank. And run very well, I must say.

In the past, this meeting has been a great chance to learn what finance researchers really think is going on in the economy and I am sure this year will not be an exception to this.

Having won a Swiss finance prize in 2008, Stanford Professor of Finance Darrell Duffie will give an acceptance presentation entitled "Policy Issues Facing the Market for Credit Derivatives" on Tuesday evening at the Société de Lecture, Geneva. I've been in touch with Darrell and among the various themes he promised to talk about will be a precise explanation of the dramatic kinetics of last year's bank failures.

I will then be taking a brief break to visit a long time friend Dr Daniele Pralong in a small town on lake Geneva. When I met Daniele at Oxford 15 years ago I would not have imagined that either of us would living be in Switzerland today, and certainly not both of us at the same time. But having arrived here earlier in the year from her most recent address in Washington DC it seems we will now be separated by a mere train ride. Great news for wordup given the better access Daniele's broad knowledge of bio-medical research.

I invite you to follow all the action here, via twitter. And I hope to coax a few words from doctoral students here using a Google's Friends Connect platform I installed for them a few weeks ago.

There are risks. You have to think about them.

Economists have predicted 10 out of the last 5 recessions. Jokes aside, economic prediction is beset with false alarms and missed warnings these days, so why should we get excited about the author of the 2006 business best seller "The Crash is Coming", Max Otte?

Professor Otte, Worms Technical University, Germany (pictured, middle) and Kanwardeep Ahluwalia, Swiss Re (right) led the discussion at this evening's Swiss Re's Centre for Global Dialogue Risk Talk on forecasting the next crisis.

Otte seems to have been spot on with his 2005 prediction of a 'financial tsunami in 2008 and certainly before 2010'. But why should we have believed him at the time?

His reasoning was based on 'very simple measures' of total debt versus gross domestic product in the US, and the fact that indexes like the Dow were rising much faster than measures of real wealth.

But the simplicity of Otte's analysis masks what is perhaps a deeper level to his thinking. After all, relatively few people predicted this financial crisis. His ideas met with a significant headwind at the time. And his ideas where not the product of complex risk models. Quite the opposite, in fact.

"You can't simply put a number on risks,' Otte explained during the discussion at the end of the presentation this evening. Earlier he had expressed a certain cynicism towards the goal of precisely quantifying risk. In a jibe towards the widely used risk model Value at Risk, Otte questioned how any organization could rely so strongly on the assumption that past volatility alone could predict a company's future risk exposure.

Physicist Dr Ahluwalia shared some interesting insights from his final days at investment bank Bear Stearns. Luck or otherwise, Ahluwalia resigned exactly one day before the company's 'fatal liquidity problem' in March 2008.

"People were not confident to enforce the risk measures that were already in place," explained Ahluwalia. Here again we see that the problem is not simply a flaw in financial risk models. The problem concerns the limits to the very application of these models to risk management.

And that is what I think distinguishes Professor Otte from the crowd. "One needs to go back to first principles and ask when will the model itself break?"

"There are risks. You have to think about them," he said.

Boost to European public-private medical research

While skeptical about green shoots in the financial sector, I am happy to herald upbeat news that the EU is pledging more than 240 million euros towards a drug research project involving leading European pharmaceutical companies, academic research institutes and a handful of biotechnology companies.

Back in 2006 I worked for a research software company called Genedata (known affectionately as the University of Genedata, pictured left). The company had a deal to work with 15 European pharmaceutical companies (basically, all the major ones) to develop quantitative tools for predicting drug safety on the basis of whole-genome toxicology findings.

The pharmaceutical industry stumps up about a fifth of the world commercial research and development budget and Big Pharma in Europe contributes generously towards Europe's trade surplus in the technology sector (still very healthy in 2008).

So it is great to see convincingly green shoots!

Is trading success all in the numbers?

I guess I'm not the only one wondering if private trading has been rendered all but impossible by the current market volatility. What is the point of me carefully building a portfolio when the entire market can be blind-sided by a single media report and placed on an entirely new trajectory?

Lately, my long time friend and former research colleague Dr Alessandro Usseglio Viretta has been applying his considerable mathematical talents to this very problem. He is using a form of machine learning known as Support Vector Machines (SVM) to perform a complex analysis of the market in real time.

SVM works by classifying stocks into simple categories, for example ‘buy’ versus ‘avoid’, on the basis of reams of market data. But while the predictions of the algorithm are straightforward, the stock picking rules created by SVM are feverishly complex. Every piece of market data chosen for inclusion in a SVM analysis is carefully factored into the final trading strategy. “It really matters what you choose to put in the model,” explains Alessandro.

Alessandro has developed a platform able to perform SVM on timescales of minutes and even seconds. This is crucial for participation in markets such as foreign exchange, not to mention volatile equity markets. “That is where high frequency trading comes in,” comments Alessandro. And note that the New York Stock Exchange has recently introduced a fee structure that is more accommodating to high frequency traders.

With an intellectual rigor befitting his early graduate physics work at CERN, and professional verve reflecting his recent collaborations with quant financial services provider Oliver Wyman, it is not surprising that traders are coming forward to test their strategies using Alessandro’s computational tools.

But in the end, will it work? “I’m doing the math, but the important thing to realize is that I am collaborating with experienced traders,” explains Alessandro. “Together, we’re in with a good chance”.

Finance research moving up the Swiss charts

Where does finance research and education fit into the response to the 2008 financial crisis? I remember studying carefully the Swiss Bankers Association dossier on the "Financial Master Plan 2015", in 2007, and finding very little about finance education (although the associated press release placed education at the top of the list of future priorities in Swiss banking).

Swiss banking expert Claude Baumann (pictured right speaking with JPMorgan's Jes Staley at a finance research conference last year) placed finance research in the top position in a recent "wake up" call for Switzerland's banking and finance community.

In an upbeat piece in Zeit Online, Baumann says that the Master Plan is still possible. Switzerland should rely on its traditional strengths: creating stability. And according to Baumann, it should continue to clean up its act as regards banking secrecy!

Swiss Re Risk Talk has cap at hand

This evening's Risk Talk at the Swiss Re Center for Global Dialogue was, as usual, excellent and assembled a capacity crowd of local business people and researchers.

World Economic Forum's Sheana Tambourgi set the theme for the discussion by reviewing the results of the WEF's new Global Risks Perception Survey. According to Tambourgi the survey distilled details of the complex and apparently escalating 'global risks landscape' to reveal a core set of risk ingredients that includes collapsing asset prices, over-stretched fiscal pledges, the future of China (and India) and of course climate.

Seems that the Survey is the result of an extensive talk-fest sponsored by the WEF involving 120 experts based in New York, London, Zurich and also Kenya, Turkey, China and India. The results have been fed into a clustering algorithm that churns out what Tambourgi calls a Risks Interconnections Map.

Each of the risk ingredients mentioned above appear as tightly interconnected clusters on the map. The map consolidates economic data from 160 countries and expert opinions on 24 separate risk categories. According to Tambourgi, the map indicates how risks interact with one another and has the potential to anticipate the "propensity of a given risk to trigger other risks".

Interconnectedness is also the theme of Swiss Re's David Bresch research focusing on climate change. As head of Swiss Re's Atmospheric Perils Group, Bresch identifies CO2 as a common thread linking together the ever growing world economic losses due to climate change.

It was at this point that the audience witnessed the re-insurance angle. Bresch presented some neat results estimating the ratio of insured versus uninsured global economic value during the past 30 years. In the mid 1980's this ratio was sitting on its historical average of roughly 50:50.

But in the last two decades there has been a dramatic rise in the proportion of uninsured global capital such that a mere 20% of it is currently covered by insurers and re-insurers. Bresch calls for action to reduce the resulting hike in risk faced by the global economy. His preferred method to hand: the creation of a global carbon market using cap and trade.

Thomas Hess, chief economist at Swiss Re, presented some very elegant mathematical models of the global financial risk landscape. According to Hess' calculations, the impact of the ongoing financial crisis on the real economy "is just getting started". His analysis focuses on an historical analysis of the default rate observed in so-called speculative grade companies.

This key business risk index typically stands at around 5%. Hess' warning about the possibility of nastier things to come is based on the observation that the current value is barely above this historical level, yet his model predicts that it will peak at 21% during the course of the crisis.

To put that percentage in perspective, the peak speculative grade default rate during the deep global recession of the early 1990s was a mere 12%. The dramatic bursting of the dotcom bubble in 2002 yielded a value of just 10%.

The problem, Hess emphasized, is the potential for this kind of upheaval to destroy good companies as well as bad. And Hess didn't seem to have the same enthusiasm for market based solutions as Bresch had presented before him. Hess quipped "When will the current crisis end? When the next bubble starts."

So can cap and trade really provide an interconnected solution to the global economic and environmental calamity we seem to be facing? The most recent news from the EU's carbon trading scheme would suggest otherwise.

Alas, we are yet to see the dawn of a new bubble in the value of carbon credits.

A sobering thought on the civility that society holds so dear

Balancing loyalty and competition is important if a group of individuals are to achieve their best in a creative and productive collaboration. Oxford sociologist Jerome Ravetz reviews a new book about scientific societies during the Enlightenment in this week's edition of Nature and reveals the subtle challenges involved in getting this balance right.

Describing the delightful civility of the British Royal Society in the seventeenth century, the book's author Steven Shapin seems to have turned a blind eye on what Ravetz calls the dark side of this very fertile period of European research: Newton's dubious treatment of Gottfried Leibniz concerning Leibniz's contribution to the development of calculus.

Ravetz reflects on the dark secrets that seem to characterize so many periods of intense innovation by considering the genteel world of the Quants in our banking system. The quiet confidence of this group of talented souls is contrasted with the violent collapse of their elaborate financial constructs during the past 2 years.

I was reminded of a comment by another researcher of loyalty and competition, Ernst Fehr. Fehr (pictured, centre) has devoted the best part of a decade to demonstrating the importance of loyalty and other forms of what he calls 'other regarding preferences' for the successful functioning of modern society.

Fehr's research presentations are music to my commune-attuned ears and sensibilities, but I am glad to have also heard him present the dark side of his position on group loyalties. On one occasion he calmly commented that "of course, the mafia also display a well developed sense of loyalty and other regarding preferences,".

As Ravetz concludes in his reflection on the contribution of civil collegiality in the financial meltdown, "[it is] a sobering thought".