A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

CHAPTER 8

COMPLEXITY, TIGHT COUPLING, AND NORMAL ACCIDENTS

Complexity is a byproduct of today’s interrelated markets. It is not always benevolent; it is at times catastrophic and is always helped along by the organizational jumble of firms like Citigroup, as well as by the host of derivative instruments that have come to dominate the financial landscape. These derivatives can be customized to meet specific needs, often with unintended consequences. Examples abound: Bankers Trust marketed a low-cost derivative contract to hedge interest rate risk, but nobody seemed to realize that the low cost masked a feature that would turbocharge losses if rates suddenly shot up, as Procter & Gamble found out $150 million later. Working in the bank’s Asian hinterlands, a young trader for Barings engaged in derivative cross-trading, amassing losses of more than a billion dollars and leading the bank into collapse. When the foreign exchange desk at Salomon Brothers wrote put options in a bet that the yen had peaked, no one noticed that the nonlinear feature of the put options magnified the loss nearly fiftyfold when the yen move 10 points higher rather than just one or two points. Granite Partners hedge fund earned a yield substantially above comparable corporate and agency bonds by specializing in esoteric mortgage derivatives, but neither Granite nor the investment banks that sold it these positions could figure out how they would behave in a changed interest rate environment.

In hindsight it ...