This Is the End


Markets, Risk and Human Interaction

June 27, 2010

Making Soccer Less Boring: A Modest Proposal

June 27, 2010
Now that the U.S. team has been eliminated, and with it the thrill of having an emotional attachment to the World Cup, I can go back to reflecting on why soccer is so boring. The basic reason is not so hard to come by: there is not enough scoring. Because there is not enough scoring, the bulk of the playing time passes with no concrete result, and the outcome is unnecessarily random. Even when a great team is matched up against a mediocre team, if you were to replay just a few critical seconds out of the hour and a half of action, the outcome might be different. Yawn at the wrong moment and miss the meat of the game.

There is an analytical basis for determining the amount of scoring a sport should have, and soccer is well below the ideal.

First, the greater the number of scores, the lower the chance for a lucky win by a team that is inferior. The number of scores required to move this random component to an acceptable level depends on the nature of the game. For example, if I were up against a professional basketball player in a game that involved each of us taking shots from the foul line, there is a reasonable chance I would win if the game consisted of only one shot each. If we each took ten shots, I would almost never win. On the other hand, if I were up against a world-class sprinter, one race – one score – would be enough. Absent a hamstring pull, he would win a hundred times out of a hundred.

Countervailing the benefit of having the outcome determined by more scores is the negative effect of having too much scoring. Up to a point, the more scores, the more interest and engagement for the spectators. But there is a turning point. Create a game with too many scores and the individual scores become inconsequential.

So in designing the ideal scoring for a sport, you want enough scores to reduce the chance of one team wining by dumb luck. The more randomness in any one score, the more scores you will want, so that a clearly superior team will win most all the time. But you don’t want to overdo it with the scoring. I think that soccer and hockey have too few scores, basketball and tennis have too many, while baseball and American football are somewhere near the sweet spot. This sweet spot can be determined empirically. A sport has enough scoring if a team that, in a large sample of games, tends to lose to most everyone rarely beats a team that tends to beat everyone.

This is all preamble to a way to improve soccer: have more scoring. It will reduce the random component, and lead to more minute-by-minute excitement. Change the game so that a dominating team wins by 10 to 5 rather than 2 to 1.

Here are a few changes I might propose in soccer to increase its entertainment value and reduce the randomness of the outcomes.
  1. Free substitution. Allow fresh players into the game. This will make for more aggressive and faster play, which should lead to more scoring. Free substitution will also allow better strategic use of players with special skills.
  2. Shorten the field. The ball will then spend more time within striking distance of the goal.
  3. Increase the size of the goal. The most direct way to increase scoring.
  4. Slope the field. Have the field slope toward the nets, both from the sides of the field and the center of the field. This will keep the ball closer to the goal area. Furthermore, this change will lead to a host of new scoring strategies. If a team can be distracted from the game -- by, say, a staged fight or a naked fan running across the field -- the ball will just roll into the goal.
  5. Use two balls. Having two balls in play will increase the number of shots, and spread out the defense. The balls can be color coded, with one ball being worth two points and the other ball one point.
  6. Add a goal tunnel. Have a corrugated metal tube that runs into the goal from beyond the goalie area. If someone can kick the ball into the tube, it is an automatic goal, since the goalie cannot defend it. New and entertaining strategies can be added with this feature. For example, players can be "tunneled" by being slammed against the sharp metal edges of the tube, thereby increasing the physical component, and with it, the entertainment value of the sport.

June 17, 2010

It's Not Your Father's SEC

June 17, 2010
This Washington Post article discusses the push in the SEC to add more market expertise. It features my colleague Gregg Berman -- who ran the risk management part of RiskMetrics -- and me.

June 16, 2010

Derivatives and the New Financial Legislation

June 16, 2010
A member of Congress asked me to provide my personal thoughts on the OTC derivatives portion of the Senate bill, S. 3217. Here are portions of my letter. The views here are my own, and do not necessarily reflect those of the SEC, its commissioners or staff.

Now that S. 3217 has passed the Senate, I am writing this letter in response to your request. I will focus primarily on the potential for that legislation to allow regulatory arbitrage and reduce transparency to the regulators.

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

As far as I was concerned, I owned the stock: I treated the swap transaction in my trading and risk management systems as if I held the stock, and my portfolio return was the same as if I held the stock.

If regulation allows equity index swaps to be under the CFTC’s regime and the stocks to be under the SEC regime, there will be the same potential for regulatory arbitrage. I can already envision a thriving new market developing for what might be called Index Spread Total Return Swaps. A fund that wants to hold a long equity position in IBM and P&G, but wants to do it under the CFTC regime, will have a broker give them a total return swap that pays the difference between a position in an index that holds the S&P 500 and another index that holds all the stocks in the S&P 500 except for IBM and P&G. This is a swap on indexes, and so will be under the aegis of the CFTC. Whatever equity positions the fund wants to hold, a swap can be created to fulfill its needs. With the push of a button, voila, the fund is effectively trading stocks – securities – under the CFTC rather than SEC umbrella.

This is a simple example of a broader point: a financial engineer could just as easily construct a position drawn from the equity market that behaves like a commodity, or create a currency swap that looks like a bond. In other words, under the proposed OTC derivatives regime, traders will be permitted to choose their regulators. In my view, these provisions should seek to eliminate regulatory arbitrage, not create it.

Another weakness of the bill is what it affords regulators in terms of transparency. As I stated in my 2007 testimony before your subcommittee, I believe that regulators should know the positions, leverage and web of counterparty connections across firms. I do not think regulators can fulfill their mission of protecting investors, the market or the economy at large without this information. The bill enhances the transparency of OTC derivatives both by improving price discovery and by pushing for greater simplicity and standardization, a critical step. However, the division of OTC derivatives oversight between the SEC and the CFTC moves us away from this objective. There is no ready mechanism envisioned within the bill to allow unfettered sharing of these data. This not only will create routes to hide abuse, but also, because what is essentially the same asset will end up in different buckets based on how it is constructed, neither agency will be able to readily amass this position and exposure information.

One last thought, based on my experience in risk management. Risk managers have the unfortunate tendency of fighting last year’s war, of developing tools and reports to prevent the crises that just occurred from happening again. Of course, the next crisis almost always comes from a different direction. To some extent, the financial legislation has a similar tendency. For example, much thought has been given to credit default swaps. It is likely, however, that the next major issue will spring from a new financial innovation. The nature of the markets is to exploit weaknesses and to find ways to work around regulation and other constraints. Because legislation can only address what has happened in the past and what is currently expected to occur in the future, the legislation must give the regulators the flexibility to address the unanticipated.

June 9, 2010

Common Sense Crisis Risk Management

June 09, 2010
All happy families are alike. Each unhappy family is unhappy in its own way. – Leo Tolstoy.

All days in a normal market seem the same, but when a crisis occurs, it seems as if we have never seen the likes of it before. Each crisis brings evocations of Black Swans with twenty standard deviation tails swimming in the waters of a hundred year flood. But of course, we have seen it many times before, or at least some aspects of it. The cause might be different, the initial market from which it propagates might take us by surprise. But the path a crisis takes, at least in broad strokes, hardly differs from one case to the other.

We all know the limitations of standard risk management methods in dealing with times of market crisis. And we are starting to get a sense of what is needed beyond these methods in order to see a market crisis coming, things like understanding who is under pressure, what sorts of positions they hold (and thus might be forced to liquidate) and who else is holding those positions (and thus who might get caught up in the propagation of the forced selling).

Common Sense about Market Crisis
Unfortunately, although we can hope that this sort of information will end up with those regulating the markets, it is beyond the realm of anyone in the private sector. But here are a few common sense things we know about the way markets behave during a crisis:
  • Equities drop
  • Volatility goes up
  • Credit spreads widen
  • Correlations rise
  • Areas of low liquidity decline more than similar areas with high liquidity
  • The yield curve flattens
Volatility goes up because everyone is jumpy, so any new piece of information leads to a big reaction, and also because there are fewer people willing to step up as liquidity providers, so prices have to move more to elicit the other side of the trade.

Correlations rise because people don’t care much about the subtle characteristics of one instrument versus another. Everything is either high risk or low risk, high liquidity or low liquidity. I think of the market during a crisis like in high energy physics, where matter melds into a homogeneous plasma when the heat gets turned up.

Because liquidity becomes critical, the less liquid markets – emerging markets, low cap stocks and the like – take it on the chin more than their more liquid cousins.

(Oh, and what about gold? Sometimes it responds, sometimes it doesn't. There is nothing intrinsic about gold that makes it part of the crisis/no-crisis equation. If it is a flavor-of-the-month market, it will respond positively, otherwise, it will simply act like a commodity, responding to economics).

Knowing this, it is not hard to take steps to protect against a crisis. Just move away from equities, avoid being short volatility, stay away from credit-laden debt, focus on the liquid markets, and watch those carry trades. Also, don’t trust diversification, because those low correlations you are depending on will not be there when it matters.

Or, if you want to be more sophisticated about it, create a variance-covariance matrix predicated on these sorts of relationships, and be sure to add a constraint to your portfolio optimization so that you will not breach a specified risk level under this crisis-based matrix. For example, if your usual risk constraint is to keep your portfolio volatility below twelve percent, perhaps you also make sure it won’t be higher than thirty percent in the case of crisis. Or, because we know the direction of these market effects, to make life simpler you can add a simple scenario test, and not allow the portfolio to lose more than, say, ten percent in that scenario. Doing this will guard against the tendency to over-rely on diversification, over-lever or put too much exposure into the markets that are particularly sensitive to a crisis.

The problem with this advice is that it is exactly the opposite of what will make sense when the crisis has yet to emerge. More to the point, it is exactly the opposite of what makes money as the market is building into a crisis.

Before a crisis (I won’t say “during a bubble”):
  • Equities are rising
  • Volatility is low
  • Credit spreads are narrow
  • Correlations are low
  • The opportunities are in the hinterland markets of low liquidity
  • The yield curve is steep
Volatility is low because everything is so rosy. Any new piece of information is No Big Deal, and liquidity is swarming around the market, so prices barely have to move to get an order filled.

Correlations are low because, in an attempt to find value in when every portfolio manager, trader and dentist is spending his time combing the hills for value, the slightest difference between otherwise similar instruments is worth mining. And with the languid pace set by the low volatility and money sloshing over the sides, people have the luxury of spending time in fine-tuning.

With so much money flooding into the market (and so much money means so much leverage), people start to scan the landscape for the less known – and less liquid – markets to find value.

Regime-switching models of market crisis
It might be reasonable to consider crises as hundred year flood events if we mistakenly treated them as being drawn from the same distribution as those normal market days. But they are not. It is following a different dynamic, a dynamic that we have seen enough to become familiar with. People sometimes look at periods of market crisis in the context of a regime switching model, and this gets more to the point. There are the normal times and then there are the crisis times. But what I am suggesting above is that there are (at least) three regimes. There are the crisis times, the normal times, and the pre-crisis times. The transition generally is not from normal to crisis, but rather from pre-crisis to crisis. And the move from the pre-crisis to the crisis regime is more gut-wrenching because in almost every dimension things are moving from one extreme to another.

The killer is that what protects you in a crisis is also what leaves money on the table pre-crisis. The best trades and market positions in the pre-crisis regime are the ones that cause the greatest losses in the crisis. The result is that those who take defensive actions will under-perform. So the the only way to stay in the game is to be as bold in the face of the crisis risk as others. As a result, in a variant of Gresham's Law, imprudence will drive out prudence.

This represents my personal opinion, not the views of the SEC or its staff.