Derivatives and the World Economy

"NATO and the United States should change their policy because the time when they dictate their conditions to the world has passed," Ahmadinejad said in a speech in Dushanbe, capital of the Central Asian republic of Tajikistan

Chaos, Derivatives, and Quantum Physics

By Cris Sheridan

Financial Sense,

11 May, 2012

Every day the financial markets get more chaotic—a fact that couldn't be made any more clear than with a recent revelation given by ex-physicist and author, Nick Dunbar, in describing a new level of complexity facing banks and derivatives. Ironically, Thurdsay night's emergency conference call by JP Morgan of a massive $2 billion unavoidable loss is perhaps a confirmation of what banks are now starting to grapple with. 

After attending a recent conference in Barcelona featuring some of the top thinkers in quantitative analysis, Dunbar says that the financial crisis has now left "quants grappling with a new landscape...that has turned the old world upside down." 
What is this new landscape he's referring to? One in which derivatives have become so chaotic that they no longer obey the classical laws of physics. The derivatives world now, he says, is beginning to operate at a level of mathematical complexity associated with quantum physics—specifically, a field known as "Quantum Chromodynamics".
Up until now derivatives mostly obeyed "simple" and definable mathematical models first invented in the 1970s. However, today, in the aftermath of the financial crisis, a new level of hyperconnectedness has resulted where "complex interactions between banks and within portfolios dominate the pricing of derivatives, as opposed to the behavior of the assets the contracts are supposedly ‘derived’ from." This math, he says, is the same for "unseen particles" like quarks and gluons "trapped within atomic nuclei."
Keep in mind that the massive multi-trillion unregulated derivatives market is what triggered the financial crisis in the first place. Even the "simple" math of the 1970s, ruled by the Black-Scholes model, was complicated enough that the balance sheets of major global banks were simultaneously wiped out due to their extremely high sensitivity to the underlying assumptions implicit in valuing derivatives. 
But now, how do you price something that defies the classical boundaries of time and space, or that changes value when a butterfly flaps its wings on the other side of the globe? The quantum realm deals with forces that are so tightly interwoven that separating one from another is nearly impossible. It would appear that Mr. Dunbar has perhaps enlightened us to an inescapable reality that, whether we like to admit it or not, the entire financial system is now bound by a single fate. 
Unfortunately, it didn't have to be this way. Through heavy lobbying and financial incentives banks convinced politicians long ago that synthetically-created derivatives didn't require regulation or oversight. Now, they've created a monster they cannot control—a monetary system that operates at a level beyond human comprehension.
Perhaps, like progress, this was all inevitable though? As the co-creator of the Black-Scholes model once said:

"The fundamental issue is that quantitative technologies in finance will survive, and will grow, and will continue to evolve over time"

Of course, this leads me back to a question I often raise: If quantitative technologies, algorithms, or—yes—machine intelligence evolves beyond our ability to control it, who then is in control? Will we really allow the financial system to slip further into the Twilight Zone or cry "Uncle!" and let Watson help manage the financial system for us? 
Then again, maybe I'm not giving those in charge enough credit? Clearly the most intelligent, well-educated scholars of human history and the markets we've been able to produce so far are fully capable of governing the financial system and seeing disasters before they erupt, right? (The video below will answer that.) 
"Hey Watson? How would you like to run the central banking system?"