Amid all the fallout from the financial turmoil, one group has yet to feel the accusing finger of blame: the analysts who built the computer software that drove the derivatives markets that, in turn, drove the financial collapse. Since the Big Bang of the 1980s, large amounts of stocks and shares — and derivatives of them — have been traded automatically by computers rather than by humans. These so-called “algotrades” accounted for as much as 40 per cent of all trades on the London Stock Exchange in 2006; on some American equity markets the figure can be as high as 80 per cent.
The people who write the algorithms that drive the software are called quantities analysts, often referred to simply as “quants.” They are generally physics and mathematics graduates working in risk management — calculating whether a given deal is a good idea — and derivatives pricing, which entails putting a figure on trades that in effect bet on other trades. It’s enormously complex, which is why only the quants could understand it — if, that is, they did. History now suggests they didn’t.
The rise of the quants has mirrored the automation of the financial markets; and as many of the newer markets, such as swaps (a sort of insurance) and derivatives, have been unregulated, the quants who have been responsible for developing the hugely complicated systems that in the end brought many of the western world’s banks to their knees. As Richard Dooling wrote in the New York Times: “Somehow the genius quants — the best and brightest geeks Wall Street firms could buy — fed $1 trillion in subprime mortgage debt into their supercomputers, added some derivatives, massaged the arrangements with computer algorithms and — poof! — created $62 trillion in imaginary wealth.”
Those algorithms were based on risk assessments that were seriously flawed, based only on the risk to the market at that moment, rather on cold, hard empirical data about a person’s ability to pay and what would happen if a lot, rather than a few of them, stopped.
It seems we are at the mercy of the machine.
— © Guardian Newspapers Limited, 2008