The Need for Speed

One of the causes for the financial crisis is the very high speed trading operations. There are several reasons that is true.

First, the high speed transaction oriented operations needs to eliminate any reflection or analysis on the part of the trading firms. There is simply no time for this. If the transactions need any analysis to support them, then that analysis must be outsourced. This is the driver behind the idea that credit risk, which for most of financial history has been seen to be a risk that required careful analysis and reflection, became a traded commodity. Banks started to merge market and credit risk and do away with their credit research staffs. This is one of the most common issues cited in explaining the crisis. Banks failure to do their own credit analysis on the sub prime loans. The lack of scrutiny led directly to the liar loans – since no one was looking at the loan applications there was no need to take any effort to make them correct.

Second, models of these risks need to be closed form models that can run instantly. More robust and complex monte carlo models that might capture the nuances of the risks were just not practical given the time frame. Monte Carlo models take too long to develop and too long to run. With a few simplifying assumptions, the need for Monte Carlo models can be eliminated and a closed form model that runs in seconds developed. The simplifying assumptions also allow the daily updating of these models. This process makes sense if and only if you believe that market prices generally reflect all information, so a closed form model that mostly just replicates and extends market prices is all that you need anyway. This approach to modeling risk makes it almost completely impossible to detect changes in the underlying risks. All users of this approach will always go over the cliff together – and they did.

Third, the speed of transactions means that there is turnover of the risks held during the year. This turnover may be 5 or 10 or 20 or 50 times. This business can easily be seen to be very, very low profit margin since capital is generally only held on the amount of risk at any one time. However, when the crisis hit, the banks were unable to continue to roll their inventory of risks and they piled up in amounts 5 or 10 times their past average holding.

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Explore posts in the same categories: ERM, Hedging, Reinsurance, Risk Management, risk transfer

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