14 Feb 2011

Lemmings in pinstripes... or why bankers love complexity

There is something to be said about the predatory financial system of the world today: For one thing, it isn't creative.

For example... Wall Street Journal reporter Scott Patterson revealed how a new breed of mathematicians and computer geniuses called "The Quants" with their complex algorithms became the blue-eyed boys of stock market trading - until they caused the 2007 meltdown.

UPDATE: I almost forgot Long-Term Term Capital Management (LTCM) run by TWO Nobel Laureates, who used "complex mathematical models" till - surprise! - they went belly-up losing billions in 1998!

Logically, the severity of the crises would dictate that the financial markets stay away from such opaque and complex equations...

But mis-incetivisation has meant that the financial system is willing to forego logic in the name of 'profit'! So now we have up to 70% of stock trading in the US and a whopping 77% of stock trading in the UK being transacted by ultra-complex alogrithms run on supercomputers in what is called High Frequency Trading (HFT)!

HFT represents stock worth tens of trillions of dollars, transacted in milli-seconds! The Quants are obviously still leading the financial lemmings.

Now there's an even bigger, and potentially more catastrophic example of denial and groupthink, in the making...

Last week, on 10 February to be precise, the International Monetary Fund (IMF) issued a report on a possible replacement for the dollar as the world's reserve currency. They say that alternative, Special Drawing Rights (SDRs), "could help stabilize the global financial system".

So what is the SDR? Well, it is essentially a basket of currencies - US Dollar, Japanese Yen, British Pound and European Pound - bundled together. According to Wikipedia, "the SDR could be considered a form of debt security".

Hmmm... The only problem is that all these currencies are essentially created out of thin air by the Central Banks - and are currently in huge over-supply. Think of all the trillions in company / sector / national bailouts, and Quantitative Easing I & II. In fact, it is this (over-supply and consequent devaluation of money) that is really fuelling inflation around the world.

But that is NOT the issue!

Where else did we heard about "bundled debt" of questionable value in the recent past?

One Gazillion Brownie Points, if you said, "Subprime Crisis".

This NOT rocket science - or financial wizardry. It is simplicity itelf... Just like the subprime crisis, a financial instrument of questionable - and at best notional - value (SDR) is being endorsed (rated AAA) by an agency (IMF) that is tasked with maintaining stability.

(Though I digress, I must urge you to please make time and watch 'Money as Debt' on YouTube.) You know what they say about being "forewarned"...

UPDATE: Here're some snippets about the foreign exchange (forex) market... London handles around 34% of world's currency trade, where Barclays Capital, Royal Bank of Scotland and HSBC are the main players. Deutsche Bank, in Germany, accounts for about 22% - making it the largest single player. JP Morgan and Citibank, in the U.S, account for around 12%.

Average value of currency traded daily was 500 billion USD in 1988. Today it is about 4 trillion USD, daily! If it is indeed an eight-fold increase in supply, what do you suppose the effect is on the value of those currencies?

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