Is there evidence that ‘losses’ may be endemic to derivatives?

May 17, 2012

Were the $2 bn losses incurred at J.P. Morgan by the London Whale avoidable? New evidence that a group in another part of the bank were buying the contracts through other banks suggests that a logic of practice undergirds the actions that allow traders to wind up these large positions.

There is a subtle distinction between the improper execution of a logic (exogenous error) and a logic that when executed leads to a collapse of value and an uneven distribution of gains and losses.  

My point is simply that financial losses are unwanted and unexpected by may unfold as a direct consequence of a logic of practice that is endemic to modern finance… even if theories of modern finance that intellectually support the development of these practices tells us otherwise.

The general idea I’m trying to get at is captured in a phrase in Rachel Maddow’s recent book on an altogether different topic where she writes: “It’s not a bug in the system. It is the system.”  

A similarly configured argument was made by Errol Morris in his film Standard Operating Procedure (2008). Morris depicts the famous photographs of smiling soldiers and dead bodies at Abu Ghraib as the just the sort of uneasy behaviour that might emerge among regular people confined to working in a situation where they bear witness intense political violence as subordinates. 

Morris’ point is that if we look beyond the frame of the pictures we will see that the disturbing actions they capture are an expected or even ‘reasonable’ outcome of the harsh conditions in which these soldiers were made to live and work.

I do not invoke Morris’ film to suggest that the London Whale was a victim of subordination or the perpetrator of violence (as others might wish to do), but rather to express that outcomes which are a direct consequences of the actions taken are not, technically speaking, errors or crises.  

Recognizing the endemic nature of a problem to a system demands an altogether different analytic and policy approach than an immediate denunciation of mistakes, sloppiness or corruption.

The approach I’m suggesting is supported by first symmetry principle of the strong programme, a founding principle of science studies.  This principle extended the analysis of science as a contingent social endeavour to groups that were able to establish firm truths instead of only studying disciplines that were considered wrong. 


7 Responses to “Is there evidence that ‘losses’ may be endemic to derivatives?”

  1. tcs Says:

    We can take either a charitable or an uncharitable view of the London Whale.

    The charitable view is that this was a dynamic hedging strategy gone awry. In essence, the lack of liquidity in the European CDS index that Iksil was trading on created an arbitrage opportunity between the underlying single-named CDSs and the index itself that hedge funds exploited. JP Morgan – perhaps due to stupidity or carelessness – allowed their hedging position to become an outright directional position, with the risks that naturally come with that. If you want to be charitable to JP Morgan, this was something of a “normal accident” that tends to happen when people employ dynamic hedging strategies in illiquid markets.

    The uncharitable view is that had things turned out differently, Iksil would have been rewarded with a handsome bonus due to the directional bets he had placed. Financial theory tells us that in the absence of arbitrage opportunities, if you want to make more money for the bank, you need to take on more risk. According to this view, this sort of outcome is inevitable where traders are paid largely via bonuses that reward excessive risk-taking that earn them handsome profits in certain states of the world.

    Either way, it seems that accidents of this sort are a natural outcome of the “system” (as you say).

  2. danielbeunza Says:

    While I agree that the Whale is an interesting subject, I think Martha’s analogy (whether explicit or, as is the case, indirect) to dead bodies in Abu Ghraib is unfortunate. If the point is that “the system” (ambiguous expression if there is one) generates occasional losses, well… we knew that already. The bodies in Abu Ghraib don’t shed new light on the issue.

  3. marthapoon Says:

    The bodies in Abu Ghraib most certainly do not shed light on the issue. Neither does the idea that ‘the system’ incurs losses.

    We already knew that.

    …But the epistemic argument made in the film Standard Operating Procedure might shed light on the issue. Morris makes a philosophical distinction between an the results of an endemic process and and exogenous failure that is rarely made is denunciatory and crisis soaked conversations about finance. This distinction is particularly lacking in political discourse around regulation in the U.S.

    The Whale did not just go down alone. It seems that the Street actively took up positions against him. If both sides of these trades were acting in the same logic then there is something more to be learned here than ‘over-incentivized and under-regulated traders make appalling mistakes’. There is a genuinely social logic at play.

    Trading in finance is a controlled form of agonistic activity. In this regard, the reference to war may not be all that misplaced. The question is: Why does the destruction of value strike us as being so exceptional? Is there, perhaps, another way of understanding these types of situations?

  4. israexile Says:

    Martha, I am interested in how you see Strong Programme symmetry here. So, please say more about it, as this would be very interesting.
    More generally, I have been following the JPM story, of course, and I love the fact that what Jamie Dimon argues is exactly the opposite of what you are suggesting: that there is nothing systemically wrong about the risk-taking procedure in JPM and it’s only localized stupidity. In philosophy of science speak: we cannot draw a categorical imperative from the behavior of JMP in the case. The implication: we should not regulate against such behavior because there is no rhyme or reason to it – it plain old stupidity.

  5. marthapoon Says:

    Hi israexile,

    It seems to me that the relationship between finance studies and science studies has become rather tenuous. It serves an institutional purpose to claim an affiliation between the two, especially in places like the UK where science studies, particularly the Paris School version, is recognized within mainstream sociology.

    But from a US perspective, where science studies remains an interdisciplinary pursuit grounded in the older tradition of history and philosophy of science, the intellectual raison d’être for science studies as a separate field is becoming diluted to the point of non-recognition within in studies of finance.

    The first symmetry principle (that we can analyze scientific practices that result in both truths and falsehoods with the same methods) is a shared philosophical starting point that unites both Paris School and Edinburgh School STS. There is no point leaping to the second symmetry principle (Latour’s symmetry between objects and humans in the account of success and failure) without having first absorbed the first symmetry principle.

    As your comment about Dimon aptly shows, the distinction between ‘true but badly executed’ and ‘false’ is at the heart of contemporary politics. I’m trying to add a third position that I think captures the unique contribution of science studies to public discourse: ‘true and well-executed but with outcomes that do not uphold the political ideal of a public interest’. To put it simply, the point of sciences studies was to show that truth itself, produced by institutions of enlightenment science, is the foremost carrier of objectionable forms of inequality.

    One last point worth throwing in: the ‘sociology’ of science studies lies firmly in the first symmetry principle. But somewhat ironically, the second symmetry principle which has become so fashionable in the UK sociology descends from systems theory, information theory and cybernetics. And arguably so do the infrastructures that have been engineered to support modern finance…


  6. PE Says:

    “But somewhat ironically, the second symmetry principle which has become so fashionable in the UK sociology descends from systems theory, information theory and cybernetics.”

    That’s one possible genealogy. The other is Greimas’s semiotics. E.g. in “Semiotics and Language” (1979) the term ‘actant’ “applies not only to human beings but also to animals, objects, or concepts” (p. 5). Then things don’t look so bad…

  7. marthapoon Says:

    Semiotics? Sure! The appeal to semiotics by Latour was arguably to give practical instructions to social scientists on how to record and write about human-object interactions which he makes theoretically important to define his distinctive brand of sociology. But Latour’s emphasis on studying human-object interactions is an intellectual extension of a concern with human-machine interactions that arises in the post-war sciences. In Latour’s work networked object-human symmetry as a philosophical principle gets generalized to all objects and humans from cybernetic (for lack of a better term) theories and theories of automation that found computing. He uses Greimas to *express* these ideas to social scientists, to provide a research method, but he is drawing his ideas from people like philosopher Michel Serres…

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: