The Plumbing is a Mess

Risk management models all assume well functioning markets. But building the markets themselves is a tough task. Sometimes the trading and the algorithms and such get way out ahead of the back room systems for execution. I’ve seen this topic recur in a number of settings recently, and its worth calling attention to them individually, and to the collective reminder that the plumbing is important, even if less glamorous.

  • Today’s Financial Times has a long piece by Thomas Briathwaite on “Elusive Information”… “the creaking data architecture that underpins modern finance.”  He calls attention to how a lack of information handicapped both managers and regulators during the Great Financial Crisis. Giving regulators basic information about the OTC derivatives market is one of the objectives of Dodd-Frank. Before that law was passed, whole parts of the market were simply dark as far as regulatory authorities were concerned.
  • For MIT’s 150th celebration, the Economics and Finance departments hosted a symposium. Videos of all of the contributions are on-line. Bob Merton gave a luncheon talk (link here), and in his talk he mentioned that one of the things that surprised him in the Great Financial Crisis was the plumbing problem: poor documentation behind some of the complex securities. The securities, he said, are not really as complicated as many people imagine, but they become complicated when the underlying documentation is not actually available due to poor back office functions. (at minute 12:37)
  • One of the ironies of the crisis in the credit default swaps market is that shortly prior to the crisis, the New York Fed had identified this as a market that had rocketed up in volume, all the while the back office was left far behind–see this archive of press releases on the subject. The NY Fed had begun a program to remedy the situation, but events overtook the effort.
  • Another irony of the current political debates about an end-user exemption from the clearing mandate for OTC derivatives, is that the lobbyists demanding the exemption are loudly proclaiming the inadequacy of many end-users’ own ability to value the derivative instruments they own. They suggest that the requirement to put up the cash collateral will be burdensome because the companies do not have the ability to calculate the size of their potential derivative liabilities. But this admission of “inadequate plumbing” actually argues for the reverse. If they cannot anticipate the size of their accruing liabilities on a derivatives contract, then it is all the more important that the system demand they put sufficient cash aside up front. A company without adequate plumbing and no collateral requirement is all the more likely to be surprised when the bills come due.

Fancy models are great. But they all assume that someone will have installed good plumbing. In many cases, we learn that the plumbing is a mess. It is a reminder that we need to look after these less fashionable parts of the business, too.

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