I began this post as a comment to Yuval’s comment on clearing (a concept that I still find very abstract). And I agree with him… an additional layer of technical complexity creates further scope for unexpected trouble. (Wasn’t it a certain Yuval Millo who coined the concept of “second order risks“?). So… right on!

But I’d like to stay on the main topic of the New York Times article. The Times writes of the New York Stock Exchange:

The buzz emanating from its famous trading floor is dying down as computerized trading has rapidly reduced the need for face-to-face transactions. In the next several weeks, the exchange plans to shut two trading rooms that were added decades ago, when its status as the place to buy and sell stocks was unchallenged.

When the latest retreat is complete, the exchange floor will be half the size it was at its peak. The “crowd” — the brokers and clerks on the floor — has dwindled to about 1,700 from a high of more than 3,000. Before the exchange became a public company in 2005, its members controlled 1,366 seats, or licenses to trade. Now, about 800 brokers pay the annual $50,000 fee for a license.

I visited the NYSE three years ago. And it is shocking that two rooms are already closing — so quickly. But at the time of my visit, an interesting sight suggested that the Exchange’s trajectory was not sustainable: tucked in a corner at the reception, there was a cloak room for shoes. That’s right: for shoes. Almost every floor trader entered in the morning, checked his leather shoes, put on rubber soles shoes, and went on the floor. The reason? That, with so many rooms and so much walking during the day, their backs were hurting. On the day that I visited, some floor brokers were experimenting with the skateboarding shoes that they saw their kids use.

Since I have not visited the Exchange again in three years, I have to confess that I am not directly familiar with the details of this change. But if the experience of the commodities exchange (NYMEX), which we visited last August, is anything to go by… it suggests that several things could happen at this point.

As Yuval wrote, what we saw at the NYMEX this past month was a remarkable a technical hybridity. Rather than the demise of a technology (in this case, pit trading), it resembled the early stages of a new technological emergence! Here’s my take on what we saw: following the gradual introduction of computers on the floor, some brokers have been laid off. Others have quit — gone to work at places like Home Depot. Others still buy and sell in the traditional way, making signs with their hands. Yet others use a terrific technology, a tablet computer that they take on the floor. Others trade from home. And other have bunched together in rented spaces in New Jersey, and trade from there.

Technological convergence? The end of live trading? It doesn’t really look like it. As I pointed in a comment, it looks more like a situation where different technological trajectories may emerge. In contexts like this, of course, is where ideas become most important — for they could push events in one direction or the other. And so the situation begs the question — what do academics have to say about this move to computer trading? What ideas exist out there? What practices? What proposals?

Daniel, the NY link of this little London-NY collaboration, sent me this link to a NY Times article about the immanent closure of some of the physical trading floors of the New York Stock Exchange. Some of the readers of this blog came to a tour of the New York Mercantile exchange where a similar message, about the rapid move from face-to-face to screen-based trading, was conveyed (see here).

This article, however, implies to yet another dimension of the move to screen-based that’s less obvious:

After becoming a publicly traded company itself last year by merging with Archipelago Holdings, the exchange’s operator merged in April with Euronext, which owned stock and futures exchanges in London, Paris, Brussels, Amsterdam and Lisbon.

This gradual amalgamation of financial markets at the institutional level into a single techno-social network means, for many institutions, that traders would have to go home (either retire or trade from outside the floor). But, this also means that markets now would use unified clearing and settlement systems (Euroclear), or in other words, that the exchanges’ risk management is gradually becoming centralised. In fact, by the end of 2007, Euroclear, who provide clearing and settlement services for Euronext will “move into the implementation phase of our platform consolidation programme, with the launch in production of the Single Settlement Engine (SSE).” It is feasible that such consolidation will deliver better efficiency, but it also raises questions about the ability to manage financial risks in a cross-owned network of exchanges that constitutes a large share of the global trading volume. For example, the operation of a unified risk management system may create inadvertent drops in prices in entire sections of the market by generating sale orders. I am sure that Euronext are much more sophisticated than this, but, at least at the conceptual level we can ask the question about the new forms of risks that are introduced to the financial markets through the creation of such exchange conglomerates.

An inspiring event just took place at Columbia. On September 7-8, David Stark and I organized a workshop on Knightian uncertainty. It brought together distinguished economists, including Nobel laureate Douglas North, as well as sociologists and management scholars, to talk about Knightian uncertainty.

Why uncertainty? It is not an exaggeration to argue that most post-war advances in social sciences have focussed on risk. From Black Scholes to Porter’s Five forces, Nash equilibrium to the efficient market hypotheses, the social sciences have modeled with great success situations in which the future can be predicted. But in a world of innovation, hedge funds, financial bubbles, climate change and terrorism, Knightian uncertainty — not risk — sits at the center of every decision-makers’ agenda. The workshop prompted reflection on these issues. What does uncertainty imply for policy-makers? for managers? For arbitrageurs? For strategists?

Here’s a few of the issues that we touched on.

First, the sheer importance of uncertainty. This was cogently articulated by Douglas North. Moving past the intellectual concern with institutions that won him general acclaim, North has turned to the problem of radical uncertainty, mental models and economic growth. North takes a really long perspective –five or ten centuries– and observes that some countries have risen from poverty to wealth, whereas others remain in misery. Why such wide differences? None of the orthodox economic explanations, he argues, account for it. To North, the explanation lies in the differences in mental models that guide the creation of institutions which, in turn, promote economic growth (or the lack of it). On the same session, Joe Porac expressed his disagreement with one of main premises of the workshop — that uncertainty is behind much of the activity that we see in the economy. Porac pointed to possible psychological mechanisms that may be having a similar effect.

Uncertainty is also central to the corporate world. For example, how should managers confront uncertainty? One of the most counterintuitive aspects of Knightian uncertainty is that the recipes that work best in a predictable world of risk can create major disasters under a scenario of uncertainty. This difficulty was emphasized by Nassim Taleb with the concept of rare events or “Black Swans.” Taleb distinguished between two realms of action: the real of non-rare events or “mediocristan,” and “extremistan.” The former describes phenomena that adhere to a normal Gaussian distribution (size of mountains, weight of people), while the latter are described non-normal distributions (wealth of Bill Gates, stock price movement in 1987). In extremistan, actors have to prepare for the potential occurrence of or rare but disruptive events. They face extraordinary success… and failure. Extremistan is where the key problems, the bankruptcies, the defaults, the shocks arise. It is particularly dangerous for decision-makers take mediocristan for extremistan, and assume they know more than they really do.

How, then, should companies operate in an extremistan-like world of uncertainty? As noted, it requires a very different organization. Firms that operate in this environment, according Anna Grandori, should espouse an “epistemic rationality”. Traditional concerns with optimality and saving resources should be replaced by efforts to discover the environment. The notion of heuristic, Grandori argued, also needs to be redefined: under uncertainty, the challenge no longer lies in recognizing familiar patterns but in discovering new models, novel relationships, etc. Search should no longer stops when performance is good enough, but when the firms’ insights make accurate predictions. The entire organization, in short, needs to be engaged in active research of one kind or another.

A different answer was provided by David Stark’s concept of heterarchy. Uncertainty poses managerial problems that go far beyond profitability. In extreme cases such as transition economies, the definition of success is itself in flux. Profits may not be the key measure of success; employment, sales, production — even location — may be the central reason why a company gains resources. How do you organize for such flux? Stark called for a different internal logic of organization — one that allows companies to adhere to competing conceptions of worth. To accomplish this, companies need to avoid hierarchy and bureaucracy. Instead, firms should pursue a dense network of horizontal interactions and distributed power relations.

The managerial problem, and more specifically the problem of strategy implementation, centered the presentation by Sarah Kaplan. Strategy involves the future. But consider the conundrum faced by an optical fiber company immeditely after the burst of the Internet bubble. A company that had been virtually living in the future for several years was suddenly confronted with a collapse in their market, as well as in their own confidence to predict the future. Kaplan identified the mechanisms whereby the company managed to restore sense and bridge their past, present and future.

Uncertain markets

How do capital markets confront uncertainty? The question goes at the heart of the conversations in the workshop, as well as at the core of Wall Street’s present headaches. Indeed, the cleavage between risk and uncertainty is at is widest in finance. From the CAPM model to the Black-Scholes equation, orthodox finance has provided Wall Street practitioners with the tools to engage in a new financial strategy, quantitative finance. But in contexts of uncertainty, those models seem to stop working and sometimes even turn against their users. In this sense, Emanuel Derman described quantitative finance in a lucid and succinct manner. Mathematical formulae, he argued, provide a mind-broadening ability to associate the value of a stock to the value of some other, seemingly different one. Unlike physics, which works with axioms, modern finance operates by analogy. But these analogies may break down in contexts of uncertainty. Examples of these include the 1987 crisis, the 1998 crisis and… the current subprime debacle (which was in the mind of all participants). What do to then?

In some ways, my own presentation addressed this very problem, and pointed to financial tools as a solution. I examined how merger arbitrageurs used a specific visualization device, known as the “spread plot,” to confront their own interpretations with those of their competitors. The spread plot provides arbitrageurs with information about what their rivals think. By alternating between their own estimates of merger probability and the probability implied by the spread, arbitrageurs stay alert to their own misinterpretations and are prompted into search. As arbitrageurs adopt financial positions, their beliefs feed back into the spread. Over time, the social use of the spread plot among the arbitrage community leads to gradual convergence in probability estimates. The arbitrageur’s solution to uncertainty, I suggest, is a financial tool: the spread plot.

Harrison Hong widened the discussion of financial uncertainty with a generalized model of disagreement in markets. His discussion centered on discrepancies between the beliefs of market actors and the ways in which these influence traded volume and price volatility. Behavioral models, Hong argued, provide some explanation for either of these, but no single model can explain extraordinary movements in both volume and prices. And yet, this is the central trait that distinguishes situation of uncertainty such as the dot-com bubble. In many ways, the concern echoes the problem raised by Beunza. Namely, that because arbitrageurs draw on all the social clues at their disposal, perception and action, prices and trading, fluctuate together. Hong presented several models in which differences in interpretation, constraints on shorting and differences in media coverage combine to yield the co-movement in prices and volume that is observed. In short, then, disagreement and differences in interpretation is crucial. Without them, one cannot account for bubbles or other periods of uncertainty.

The role of disagreement on Wall Street was further studied by Raghu Garud. A key group in this setting is Wall Street’s securities analysts. They play central role in articulating, using and debating different perspectives about company value. Garud described the role of analysts in advancing different opinions about Amazon.com during the emergence of the Internet. Analysis even interpreted the same piece of news in radically different manners. Eventually, however, their differences in interpretation collapsed when the milestones and rhythms promised by the dot-com optimists were not confirmed by events. But the process took three years.

Uncertainty and strategic interaction

What does “strategy” mean when the opponent is unknown? Traditionally, strategic interaction has been studied in game theory. But according to Adam Brandenburger, game theory can sometimes be unhelpful; specifically, orthodox game theory typically assumes that both players in the game know how the other person thinks, her interests and her payoffs (the so-called assumption of “common knowledge”). Bringing uncertainty into our understanding of games radically shifts the problem from an abstract exercise of calculative anticipation into something much different. In the so-called school of “epistemic game theory,” strategic interaction is seen instead as the way in which the players discover each other. What does the other person think? What does he or she stand to gain and lose?

In understanding “the other,” it is helpful to keep in mind the logic of justification that defines him or her. According to Laurent Thevenot, it is not the same to operate in a domestic regime (one rooted in tradition) than in a market setting (determined by competition) or a civic setting (shaped by the general interest). These different regimes not only bring with them different geographical locations, goals and metrics for success, but even differences in values. Such multiplicity of worth has been studied in detail by the French school of “economics of convention.” Conventions, according to them, are the solution to the problem of coordination in games.

But how does a convention arise? Such was the question addressed by Olivier Favereau. The heterodox economist explored the process whereby a collective of people who do not share a language are able to espouse a convention, underscoring the role of intersubjectivity in bringing about common knowledge.

All in all, an extraordinary event. The description above only begins to scratch the surface…. very soon, I’ll also be reporting on some very provocative commentaries by Bruce Kogut, Harrison White, Yuval Millo, and Fiona Murray.

Stay tuned.

The myth of virtuality

July 12, 2007

Increasingly, I hear and read in academic forums about the ‘virtuality’ of derivative markets. The notion that these markets are ‘not-real’, disjointed or otherwise exist ‘outside economy’ is raised frequently in sociological papers. This notion is also accompanied, more times than not, by the would-be implications of that ‘virtuality’. That is: what can derivative markets do because they are ‘virtual’? For example, derivatives and liquidity. A few months ago I listened to a paper in which the author claimed that because derivatives can be written on the basis of anything, are written for a very large variety of underpinning assets that can be exchanged, derivative markets provide, in effect, an almost infinite liquidity!

Another area affected by the ‘virtuality’ syndrome is the concept of leverage. Many derivatives allow high leverage and, consequently, there is a high ratio between the volume of derivatives contracts traded (nominal value) and contracts that get exercised (exchanged for the underpinning asset). The common argument following this characteristic of derivatives goes along these lines: “the annual nominal value of exchange-traded derivatives exceeds the global GDP [so far so good] and therefore it is obvious that these markets are completely divorced from any normal economic activity and are responsible for the hyper-capitalism we currently witness, the widening gap between rich and poor …” You get the drift.

True, the nominal value of derivatives traded is indeed astronomical and it is true that only a fraction of that volume is exercised. Additionally, it would be fair to say that the operation of many derivatives markets is hinged upon maintaining such a condition. However, does this fact make derivatives markets virtual? Let me put it differently. If the high ratio between held contracts (or even assets) and exercised assets is a mark of a virtual market then one does not need to delve into the exotic world of swaps, binary options and other financial beasts to find ‘virtual’ markets. In fact, to find them, it is enough to look at the boring, old stock exchange. On a extremely busy day in the New York Stock Exchange only between 1.5 and 2.0 per-cent of the Dow Jones Industrial Index stocks held by the public change hands. Yet, this minute amount determines a price change for the rest of un-traded bulk of stocks. Moreover, the validity of the price quoted for stocks is conditioned on the very fact that only a relatively small minority of owners would want to trade them at any given moment. If, for example, one morning 90% of the owners of IBM shares would decide to sell them, it is fairly obvious that the large majority among them would not receive a price that is even close to the price quoted for IBM the previous day… So, we see that the stock market, very much like the dreaded derivatives market is based on a high ratio between exercised and held assets. Well, then, is the stock market also ‘virtual’.

An even more ‘basic’ example for the same phenomenon is commercial banks’ reserve ratio. All sociology textbooks refer to the self-fulfilling nature of ‘run on the bank’: a bank’s customers, believing that there may be a liquidity problem with the bank, withdraw their savings and thereby cause a liquidity problem. But, let us now examine the common situation in which the cash-to-loans ratio is kept. It is obvious that not all the deposits are readily available in the bank, the same way that not all stocks can be exchanged simultaneously and not all derivatives can be exercised. So, does this make all there institutions virtual? Following the logic of the hypothetical (but sadly, very realistic) quote presented above, the answer must be: yes. All financial markets include such an inherent ‘virtual’ element. So, does this mean that there are no distinguishing factors that make derivatives markets worthy of a focused sociological analysis? Certainly not; it only means that if we want to talk sociologically about derivatives markets, we may have to discard the false concept of ‘virtuality.

I see that the “molecules” saga is continuing… So here’s my small contribution to it: following Callon and Latour, I like the idea of a language that shifts from flesh-and-body individuals to people equipped with artifacts. And a new metaphor may facilitate that transition. Is “molecules” the best possible one? Well, one thing about molecules is that it keeps the reminiscence with physics… and its epistemological baggage.

And the baggage is heavy. Economists recast their social science as physics with the quantitative revolution in the 1920s… Econometric Society, Econometrica, Cowles Foundation, etc. Part of the idea was rhetorical: to claim for their discipline the existence of “fundamental laws” of markets that they would go on to discover with the use of models… This, of course, is an idea that the performativity agenda has challenged. Models don’t capture fundamental laws, but also create them. So one would think that molecules and performativity don’t go together.

The question then is… what other metaphor best captures the notion of markets made up by calculative ensembles?

One of the more interesting developments in the Social Studies of Finance is the extensions of its methods and approaches to other business phenomena. Just as SSF examines the practice, technology and content of the financial value claims, a growing literature is addresses with similar questions in marketing, strategy, etc.

An interesting panel session, organized by Catelijne Coopmans and Elena Simakova at the 2007 Academy of Management meeting in Philadelphia is concerned with this question. The meeting, part of the Professional Development Workshop programs is titled, “Does STS Mean Business? Interdisciplinary engagement as a source of theoretical innovation” and will have the presence of Raghu Garud, Peter Groenewegen, Peter Karnoe, Christian Licoppe, Eamonn Molloy, Wanda Orlikowski, Marc Ventresca and Ragna Zeiss (as well as myself, Daniel Beunza).

According to the organizers

This workshop addresses the opportunities and challenges arising from the interaction between organization and management studies on the one hand, and science and technology studies (STS) on the other. Taking up the theme of this year’s conference, we observe that STS concepts and scholars are arguably ‘doing well’ in the management arena, but what does it mean for them to do ‘good’? The contributions to this workshop offer various perspectives on (1) what a valuable engagement between organization and management studies and STS looks like, and (2) what such an engagement contributes to existing knowledge and ways of doing research. Potential tensions between being useful and being critical are thereby high on the agenda. The workshop also addresses possible implications of how the engagement between management studies and STS is being framed.

It will take place on Saturday August 4 2007, 9am-12pm at Philadelphia Marriott in Franklin 3. No registration required. For a detailed program, click on: Does STS Mean Business? Program

David Martin has organized a very remarkable panel titled “Ways of Performing Finance” at the 2007 annual meeting of the Society for the Social Studies of Science. The session will take place on saturday October 13th.

The papers are the following:

“Distributed Calculation: Artifacts for Deliberation in the Capital Markets,” by Daniel Beunza and David Stark (Columbia Business School / Center on Organizational Innovation)

“Making Corporate Social Responsibility Calculable and Legitimate on Financial Markets: The Social Construction of Socially Responsible Investment in France” Jean-Pascal Gond (Nottingham U)

“Governing global banking organizations: On the significance of organizational knowledge in regulatory practices” Matthias Kussin (U Bielefeld)

“Mutual Legitimization Process of ‘Market’ and ‘Theory’: the example of Volatility Forecasting” David Martin (U Toulouse-France)

“Making stock pricing methods performative: the everyday logics of interaction of professionals in contemporary finance.”
Horacio Ortiz (Ecole des Hautes Etudes en Sciences Sociales)

“Moral Behavior in Stock Markets is Shaped by Mandates and Market Structure” Aaron Pitluck (Illinois State U)

“How to be Fair in Finance? Knowledging Actuarial” Ine Van Hoyweghen (U Maastricht)

“Fairness in the Insurance and Reinsurance Business” Jacques-Olivier Charron (CNAM/LIPSO)

“What’s the market wage? How compensation surveys give form to the financial labor market” Olivier Godechot (Centre Maurice Halbwachs-CNRS/ENS/CEE)

“Comparative study of credit scoring in the USA and France” Martha Poon (UC-San Diego / CSI-Ecole des Mines de Paris)

The gathering is remarkable, I believe, for the diversity of its participants. It comes to show the strength of the performativity agenda, especially in the European intellectual space.

The journal Accounting, Organizations and Society is planning to do a special section on social studies of finance and accounting. The deadline for submitting contributions is August 15, 2007.

The title of the section is: Tracking the numbers: Across accounting and finance, organizations, markets and cultures, models and realities. Here’s the editor’s description:

Studies of finance and those of accounting as social and institutional practice are united by an interest in analyzing social settings, organizations, cultures, markets and institutions characterized by a high frequency of circulating numbers. Across these fields and the associated scientific disciplines, a remarkable number of researchers has by now become engaged in investigating how the use of numbers and various social settings co-develop, change or persist. While interdisciplinary research in accounting has largely focussed on organized settings of calculative practice, the employment of numbers in programmes and technologies of government, and the respective roles of accounting professionals, social studies of finance have been more concerned with exploring the construction of markets and market cultures, and the role of numbers and calculations in bringing about these constructions has mostly been a more implicit analytical issue. Perhaps such differences are part of the reason why correspondence across social studies of finance and interdisciplinary research in accounting has remained regrettably limited.

AOS, as the journal is known, is published in England and read internationally. It has led the growth in the literature on “critical accounting,” as well as published research at the intersection of accounting and organization theory.

Papers can be submitted either by e-mail
(hendrik.vollmer@uni-bielefeld.de) or by post to:

Hendrik Vollmer
Universitaet Bielefeld
Fakultaet fuer Soziologie
Postfach 100131
33501 Bielefeld

The New York Times recently reported that farmers of live hot and cattle in the Midwest have complained about the pernicious effects of Wall Street commodity index funds on their farms. These funds, it turns out, have suddenly become very prominent, making up for 47 percent of long-term contracts for live hog futures and present also in wheat, live cattle and corn. Why the complains? According to the article…

Many in the agriculture industry say that the index funds are increasing volatility, widening the spread between low and high bets on future prices, not only because of their sheer size but because the funds have tended to move in herds in response to market signals. Because the funds are prohibited from actually owning physical commodities, they ”roll” their futures contracts each month, often helping make the prices for commodities in future months higher. And each year the funds rebalance their portfolios in Robin Hood-like fashion, taking profits from commodities that have risen in price and reinvesting them in other, lower-priced commodities. The goal is to keep the commodities in the baskets at certain weighted percentages.

The key to the article is, why this sudden interest of Wall Street on pigs and sheep? Agricultural products, it turns out, are lumped together with energy products under the common umbrella of “commodities” index. The recent rise in energy prices has made commodities indexes very attractive, leading to increasing investment. The by-product of this has been a surge in agricultural positions of Wall Street funds. Interestingly, the farmers counterattacked by contesting the diffinition of commodities index, persuading the Commission to separate index funds in a separate category.

The news comes as traditional indexes are being combined, blended and deconstructed all over the country. Recently, another piece in the New York Times discussed the recent difussion of “fundamental indexers,” that is, funds that reweight traditional indexes such as the SP500 to correct for market imperfections. These developments prompt numeros questions to academics — what’s an index, really? How do they transform and reconstitute the securities they are supposed to represent?