Hillspoint

Below is an open letter to Sepp Blatter, President of FIFA

Dear President Blatter:

I realize that you have been under enormous pressure to use video replay technology for controversial plays during this World Cup, and one would assume that this pressure will not subside any time soon, as it is inevitable that future official calls on the field will be criticized by fans and the media alike.

My understanding is that a major part of the reluctance to move to video technology stems from a concern that it would slow down the flow of play, and this is quite understandable as a concern -- football is a continuous play sport, part of the "beautiful game."

Can I make a modest suggestion that would, in my judgment, not impede the flow of play considerably but also allow for more contentious calls on the field to be adjudicated relatively quickly. Let's call it a "three challenge rule" -- or even two challenge -- that would allow each team to challenge a referee's decision during a match. The challenges would be used when a team felt it strongly disagreed with an official's call. Another referee who would have access to video -- or possibly the head referee could go quickly to the sidelines to review -- and provide a judgment within a minute or two. It seems to me that given the stoppage time currently afforded to injuries -- real or not -- having a challenge system would not significantly slow the pace of the game, particularly since they are limited in number and managers would have to use them wisely.

It would allow for a more equitable solution to today's current state, particularly given the enormous efforts each team and country must make in reaching such a grand tournament.

Complexity and Financial Innovation

A recurring theme underlying much of the current discourse over financial regulation is the increased complexity of the industry and in particular the emergence of products which may have contributed to the recent crisis.

Complexity, however, can be a difficult issue to pin down, both from an academic and laymen’s standpoint. Putting safeguards in place for consumers, for example – the rationale behind the proposed Consumer Financial Protection watchdog, part of the financial reform bill proposed by the U.S. Senate – can only be effective if the watchdogs themselves fully understand the process of innovation and the resulting end products. How will we determine the safety of future financial products in much the same way we determine product safety in non-financial products? We have witnessed how the major rating agencies have done a poor job in evaluating the creditworthiness of various bonds and securities at the heart of the crisis. What makes us more confident that a consumer overseer can do a better job? Moreover, it has been noted that the chief executives of many of the largest financial institutions did not have a good understanding of the risks posed by products their employees were trading.

Perhaps another way to understand complexity is within the context of market evolution and commoditization of certain primary markets. The typical path is something along the following lines: first, innovation leads to creation of products that are bespoke or developed for a small community within the broader marketplace. Initially, such products are traded between individual banks and firms in the so-called over-the-counter (OTC) market and in relatively small volumes. There is no formal exchange for such products just yet, but over time if they are seen as providing a valuable service, be it in the form of risk mitigation or capital allocation, demand will grow, prompting the eventual creation of a larger marketplace where buyers and sellers can be more easily accommodated.

As markets mature, several key features emerge. Foremost, these include price transparency, which reduces the cost of price discovery. Transaction costs are next impacted, with technology playing a key influencing role, enabling scalability and enhanced liquidity. Settlement costs also decline and ultimately products reach a stage where there is little value added by the initial intermediaries.

For intermediaries the early stages of product evolution are the most profitable because of (1) the high degree of customization involved – think Savile Row tailors – and (2) the subsequent task of matching buyer and seller; the latter requiring a heightened form of market intelligence and broad network of potential clients. Both tasks are very labor-intensive and as such banks can charge clients a hefty fee or premium for both the development and execution of the transaction.

Once such products become more standardized, and rules are agreed governing their trading and settlement – such as U.S. Treasury securities – the value added by the middleman declines along with the profits. For large, diversified banks it is therefore understandable that they would wish to delay movement towards a more formalized market organization for products that contribute greatly to their bottom lines.

The Senate bill, which is in reconciliation with the House version, proposes that complex derivative products should move from the OTC market to exchanges and pass through clearinghouses. Such a requirement is meant to insure greater price transparency and settlement guarantees, with the hope that the opaqueness witnessed in such products during the financial crisis will be greatly lifted.

What remains to be seen, however, is how regulators determine when a product is ripe for a move toward an exchange trading forum? Will regulators establish certain criteria or parameters in terms of notional value outstanding or volumes traded as a prerequisite for moving certain derivative products from the OTC market to an exchange? If so, will such criteria become publicly available in advance or will regulators retain the right to pick and choose, dependent perhaps on the advice from the council of regulators created to monitor systemic risks – another feature of the Senate bill.

One can well imagine that such questions are buzzing through the minds of senior management at some of the industry’s largest firms as they grapple with how financial product innovation will evolve in the future. No doubt they will seek to retain the right to create new products whereby their intermediary role in terms of customization and market making allows them to carve out a substantially higher margin than what they would earn on more established markets and exchanges.

What remains unclear, however, is just how product innovation will evolve; how regulators might intervene in a product’s future development and the requirements banks may have in terms of providing greater transparency early on.

The one thing that does seem clear, though, is that this great source of profit margin will be much smaller than in the past as regulators seek to prevent banks from maintaining such an intermediary role indefinitely.

 

Oil & Money: A Lack of Creative Foresight?

If there is one thing the British Petroleum oil disaster and the global financial crisis have in common is a lack of consideration of the unexpected or more formally a process that focuses on alternative futures which are outside the bounds of what most senior managers view as possible – in other words, scenario planning.

Ironically, scenario planning as a risk management tool was introduced into the private sector by a major oil company in the 1970s, Royal Dutch Shell. Previously, it was a technique used by military planners to develop simulation war games. As Pierre Wack, a senior strategist with Shell at the time commented, “Scenario planning is a discipline for rediscovering the original entrepreneurial power of creative foresight, in contexts of accelerated change, greater complexity, and genuine uncertainty.”

We have all witnessed how the global financial system has become much more complex in a relatively short period of time. Attempts to capture such change and complexity through quantitative modeling have proven woefully inadequate when the unexpected lies outside the bounds of pre-determined rationality. Financial markets, as we have seen, are not the subject of controlled laboratory experiments, where techniques from the physical sciences can be applied with rigor and certainty. The human element, as always, remains unpredictable as much as we wish to believe otherwise.

In the case of BP, the lack of “creative foresight” appears even more disturbing in light of its disproportionate exposure to deep sea drilling when compared to competitors. As has been well-documented, the company’s planning and solutions for a deep-sea spill was severely lacking. Highlighting this lack of preparedness, BP’s chief executive, Tony Hayward, conceded in a recent newspaper article that “we need to be better prepared for a sub sea disaster. It is clear that our industry should be better prepared to address deep sea accidents of this type and magnitude.”[1]

His invocation of the royal “we” suggests some insider knowledge that BP may not be alone in its inability to handle a deep-sea catastrophe. Of course, we do not know this for certain. What we do know is that BP was not prepared. Within the precepts of scenario planning, thinking the unthinkable and how to position a company for such events must be led from the top. Without such guidance a company will never invest in the tools needed to handle such unpredictable events.

Ultimately, scenario planning takes senior managers outside the comfortable confines of their mostly linear projections of the future and forces them to consider events or scenarios that could impact their company in ways that are not easily quantifiable. This is a difficult process not least because many senior managers believe they have reached their lofty station in part by exceptional vision.

To convince management that their expectations might be trumped by something they currently consider highly unlikely is an exercise in recognizing the limits of current wisdom as well as opening the door to the possibility that one might be wrong – not an easy admission for many. In addition, if scenario planning is taken seriously, investment in long-term solutions is required or a positioning of the company to anticipate the unlikely. This makes the process that much harder by having to set aside part of a firm’s annual budget for events that are deemed to have a low probability. In the case of BP as well as and many firms on Wall Street, while such unexpected events were given a low probability, it is clear that their realization contained the seeds of ultimate corporate destruction.

If scenario planning is imbedded in the normal course of a company’s risk management process, senior managers must demonstrate a willingness to suspend normal quantitative techniques and engage in a creative, subjective process that stretches their imagination. However, this need not be an exercise where we start from scratch each time. Within the financial industry, for example, we have had numerous past crises which can serve as a starting point for such creative dialogue.

Behavior is difficult to change, and often a crisis is needed to jolt a company from its complacent ways. Mr. Hayward now concedes that the oil “industry” must learn from the Gulf disaster and take steps to prepare for similar future events. This approach, of course, gives the chief executive cover to invest in solutions that would hopefully mitigate a future disaster. It is unclear whether Mr. Hayward and BP will remain in a position to learn from the Gulf crisis and invest accordingly. At a minimum, let us hope that its competitors learn and take steps to incorporate the unthinkable in their corporate planning.

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[1] “What BP Is Doing About the Gulf Gusher,” Wall Street Journal, June 4, 2010

The Internet & How You Think

I came across John Brockman's annual question today, "Has the Internet Changed the Way You Think," and found this contribution from Brian Eno:

THE 'AUTHENTIC' HAS REPLACED THE REPRODUCIBLE

I notice that some radical social experiments which would have seemed Utopian to even the most idealistic anarchist 50 years ago are now working smoothly and without much fuss. Among these are open source development, shareware and freeware, Wikipedia, MoveOn, and UK Citizens Online Democracy.

I notice that the Net didn't free the world in quite the way we expected — repressive regimes can shut it down, and liberal ones can use it as a propaganda tool. On the upside, I notice that the variable trustworthiness of the Net has made people more sceptical about the information they get from all other media.

I notice that I now digest my knowledge as a patchwork drawn from a wider range of sources than I used to. I notice too that I am less inclined to look for joined-up finished narratives and more inclined to make my own collage from what I can find. I notice that I read books more cursorily — scanning them in the same way that I scan the Net — 'bookmarking' them.

I notice that the turn-of-the-century dream of Professor Darryl Macer to make a map of all the world's concepts is coming true autonomously — in the form of the Net.

I notice that I correspond with more people but at less depth. I notice that it is possible to have intimate relationships that exist only on the Net — that have little or no physical component. I notice that it is even possible to engage in complex social projects — such as making music — without ever meeting your collaborators. I am unconvinced of the value of these.

I notice that the idea of 'community' has changed — whereas that term used to connote some sort of physical and geographical connectedness between people, it can now mean 'the exercise of any shared interest'. I notice that I now belong to hundreds of communities — the community of people interested in active democracy, the community of people interested in synthesizers, in climate change, in Tommy Cooper jokes, in copyright law, in acapella singing, in loudspeakers, in pragmatist philosophy, in evolution theory, and so on.

I notice that the desire for community is sufficiently strong for millions of people to belong to entirely fictional communities such as Second Life and World of Warcraft. I worry that this may be at the expense of First Life.

I notice that more of my time is spent in words and language — because that is the currency of the Net — than it was before. My notebooks take longer to fill. I notice that I mourn the passing of the fax machine, a more personal communication tool than email because it allowed the use of drawing and handwriting. I notice that my mind has reset to being primarily linguistic rather than, for example, visual.

I notice that the idea of 'expert' has changed. An expert used to be 'somebody with access to special information'. Now, since so much information is equally available to everyone, the idea of 'expert' becomes 'somebody with a better way of interpreting'. Judgement has replaced access.

I notice that I have become a slave to connectedness — that I check my email several times a day, that I worry about the heap of unsolicited and unanswered mail in my inbox. I notice that I find it hard to get a whole morning of uninterrupted thinking. I notice that I am expected to answer emails immediately, and that it is difficult not to. I notice that as a result I am more impulsive.

I notice that I more often give money in response to appeals made on the Net. I notice that 'memes' can now spread like virulent infections through the vector of the Net, and that this isn't always good.

I notice that I sometimes sign petitions about things I don't really understand because it is easy. I assume that this kind of irresponsibility is widespread.

I notice that everything the Net displaces reappears somewhere else in a modified form. For example, musicians used to tour to promote their records, but, since records stopped making much money due to illegal downloads, they now make records to promote their tours. Bookstores with staff who know about books and record stores with staff who know about music are becoming more common.

I notice that, as the Net provides free or cheap versions of things, 'the authentic experience' — the singular experience enjoyed without mediation — becomes more valuable. I notice that more attention is given by creators to the aspects of their work that can't be duplicated. The 'authentic' has replaced the reproducible.

I notice that almost all of us haven't thought about the chaos that would ensue if the Net collapsed.

I notice that my daily life has been changed more by my mobile phone than by the Internet.

The Few And The Many

As I continue to ponder the current financial crisis, discovering almost daily new departures by colleagues who are more gifted than I am, a recurring theme comes into play, one that only barely gets mention in our financial press: this did not have to happen.

 

Some events are controllable, most are not. In the economy, individual actors typically have a small role to play in influencing the outcomes for the many. Government certainly has such a role and can reshape the direction and fortunes of the many through taxation and monetary policies. Yet even here, the effect is often delayed and uncertain in its ultimate magnitude.

 

What is most striking about this global crisis is how it was engineered by a handful of institutions engaged in the type of financial product innovation that put client interest behind short-term profitability. The repercussions of such innovation through the systemic linkages of a largely unregulated credit derivatives market and the broader economy are astounding, to say the least. One can certainly argue the lack of government oversight had a role to play – but the primary actors, those charged with fiduciary responsibility to their customers, were clearly in the driver’s seat. Their failure in managing the potential risk of such innovation lies at the core of the crisis that will result in enhanced regulation and diminished scope for risk taking.

 

But when one considers the amount of wealth destruction that such engineering has engendered, one might also ask where is the accountability? Can a market-based economy allow managers of major financial institutions to walk away from their past failed policies with little more than a smaller 401K as punishment?

 

Many more individuals have been gone to prison for much less. This inequity may well come to haunt us again in a future crisis, allowing the type of disregard for the client to perpetuate. Ultimately, this financial crisis is a crisis of conscience and culture. What will change that remains to be seen.

 

 

http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom

A Thought on Risk from Chesterton

From G.K. Chesterton, 1909

"The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait."

We might do well to ponder the thoughts from far afield and re-visit others whose insights into the irrational side of human behaviour have been well-documented.

Has Financial Innovation Run Its Course?

The financial pendulum in America has yet again swung wildly out of kilter, leaving behind thousands upon thousands unemployed; fortunes and savings lost and economic instability, at a time of already heightened risk, hugely magnified.

Yes, we are here again cleaning up a mess that some of our best and brightest have created; financial engineering that leaves most common men bewildered and at a loss to understand. As someone much wiser once said, “If you can’t understand it, don’t buy it.” Yet buy it they did en-masse, with easy money fuelling an endless stream of profits and countless stories of Midas riches.

The fall of the House of Lehman owes itself in part to financial innovation run amok; the much-heralded securitization model having proven to divorce itself from economic reality in the most startling fashion witnessed in modern finance. Securitization, it was said, was supposed to diffuse risk; spread it around the many so that concentration in the few would be minimized. Alas, the few have been brought to their knees, with the model not having worked as planned.

Yet there is perhaps a more disturbing aspect to this tale, one that we must ponder quite carefully if we are to avoid pushing the pendulum back too far in the other direction. While financial innovation may be something we should try to curb – and there is much talk now about turning the clock back to the good old days of the 1950s and 1960s when banks simply took deposits and made loans – one wonders whether the real culprit in this latest tumult has more to do with the character of those running our mammoth institutions.

If we look at our current political landscape and listen carefully to what is emanating from certain quarters, there is a view that America ’s influence in the world has been diminished due to the arrogance of its recent leadership.

It’s not entirely clear – and this is something historians will likely dig into at some point – but there does seem to be a generational shift among our political leaders in terms of certain values: humility, collaboration, co-operation versus what would appear to be today’s norm: single-mindedness; lack of respect for institutional values or the rule of law; arrogance?

Financial institutions have a special role in society because of the fiduciary responsibilities they are charged with upholding. They are supposed to be bastions of security and sobriety; halls of rigorous analysis and scrutiny; pillars of prudence and caution. Do any of these values ring true when one views recent events? If anything it would appear that a potent mix of de-regulation and generational change has rendered these institutions more akin to gaming parlors, where profitability is the primary goal at the expense of all others.

Years ago if one contemplated a career in banking one of the incentives was stability in employment. Stability in employment is often associated with an industry that provides an indispensible service to the community and where risk is relatively low – a bit like the post office, one might say. Of course, working for the House of Lehman or Morgan or Citigroup is about as far removed from the U.S. Postal Service as one can get. Job security is traded against high income; risk taking against risk aversion; monolithic decision-making against collaboration.

When contemplating what the next steps should be in the reformation which looms on the horizon, our policy-makers might consider what types of individuals they wish to see replace the current generation. They might also do well to ponder the role boards of directors actually play in these institutions and the types of incentives they provide in recruiting the best and brightest.

If there is a silver lining, today’s financial turbulence might prompt some young bright lights to pause when considering a career in finance, a hesitation that might serve us all well if the alternatives pursued enhance our competencies in the sciences, the environment, education, public service and beyond.