Thought Leaders: Finance
Precarious Progress
Richard Bookstaber
06/01/2007

Wall Street is becoming riskier and riskier. Crises and catastrophic losses seem commonplace. This is odd, considering investors are more sophisticated now, enabled by an increasing array of financial products and protected by more government oversight than ever before.

The risk we see in the financial markets is not a reflection of growing economic uncertainty. By most measures, the economy is far less risky today than it was a generation ago. GDP, for example, is less variable and recessions are shorter and shallower. Today’s rising market risk comes from the design of the market itself.

At the forefront are Wall Street innovations such as derivatives and swaps, as well as Main Street instruments like interest-only mortgages. Many such innovations are designed to control risk, but in aggregate they tell another story. More financial innovation results in greater market complexity, unexpected outcomes from market shocks and a mechanism for investors to skate on the edge with ever-higher leverage.

The relationship between innovative instruments and market crises is not new. In fact, the poster child of all market bubbles, the Holland tulip mania in the 1630s, came about due to a financial innovation. The explanation for the mania usually centers on the irrationality of the market, but this misses the point. Horticulture was an avocation for many wealthy Europeans in the 17th century. Rare bulbs fetched huge sums even before the mania, and continued to do so decades afterward. Clearly, the price of bulbs did not fuel the speculative fervor. Instead, the development of a forward market for tulips in 1635 set the stage for disaster.

In that forward market, the physical commodity did not change hands. Instead, speculators traded ownership certificates. Individuals purchased the bulbs and then sold them for future delivery. Money changed hands only after the seller delivered the bulbs. Speculators had no intention of holding onto their contract for delivery. They planned to close out their commitments before they came due, so they could buy the bulbs without the capital to make a physical purchase, then sell bulbs they did not own. The forward contracts allowed speculators to operate with infinite leverage. Then as now, with infinite leverage can come infinite demand.

Crises and catastrophic losses seem commonplace.

Our more advanced innovations continue to propagate the same flaw: They facilitate financial leverage, and with that leverage comes the capacity to spawn crises. The leverage facilitated through swaps and the collateralized financing of investment banks were at the core of one of the great collapses of the latter part of the 20th century, the demise of the hedge fund Long Term Capital Management.

Present-day innovations have added another design flaw to financial markets—and make them far more complex. Options, caps, floors and other derivatives have nonlinear payoffs. In some cases, a 1 percent drop in price might mean a 1 percent loss for a derivative instrument, while a 10 percent drop in price might mean a 50 percent loss. If an investor misses some facet of this nonlinearity, those one-in-a-hundred instances of major market dislocations become magnified into once-in-a-lifetime surprises. This complexity, manifest through an optionlike innovation called portfolio insurance, was at the center of one of the other momentous crises of the recent past: the crash of 1987.

On their own, higher leverage and complexity each contribute risk to the market, but the bigger problem arises when the two merge. When this happens, the complexity leads to unexpected losses, and the leverage magnifies the result and limits the time available to recover.

We can begin to conquer these risks by thinking twice before throwing the next new financial instrument into the market. Just because we can turn some cash flow into a tradable asset, doesn’t mean we should. Just because we can create a new type of forward contract to trade, doesn’t mean it makes sense to do so. Granted, if you are the one marketing the instrument, these innovations make sense because you can find profit margin in them. But looking beyond the bottom line of the issuer, trying to design a market to allow limitless trading possibilities will cause more harm than good because each innovation adds layers of increasing complexity and further opportunities for leverage.

Illustration by Matt Mahurin.

Richard Bookstaber, the former director of risk management at Moore Capital Management, runs an equity hedge fund in Greenwich, Conn., and is author of the new book A Demon of Our Own Design: Markets, Hedge Funds and the Risks of Financial Innovation.