Financial Cryptography

Success has many fathers, but failure has the US taxpayer

The USA financial mess was seen taking a brief pause, with almost 24 hours going by without another new world record in greatest failures ever. Morgan Stanley gamely held on ... But even as we speak, they are preparing the mother of all bailouts. It's the weekend, of course, and recent tradition has it that only on Sundays is it right to sell the free market. Or something.

Since the crisis began more than a year ago, the Treasury and Federal Reserve have already put nearly $1 trillion of taxpayer money on the line to help credit flows, while banks have suffered more than $500 billion of write-downs and loan losses.

A trillion here, 500 billion there. 700 billion by Monday? Pretty soon we'll be talking about real money.

The deficit for this budget year, which ends on Sept. 30, is expected to rise to $407 billion, a figure that is more than double the $161.5 billion imbalance for 2007, reflecting what the economic slowdown and this year's $168 billion economic stimulus program are already doing to the government's books. And that forecast doesn't include the $200 billion the administration committed to spending two weeks ago when it took over the nation's two biggest mortgage companies, Fannie Mae and Freddie Mac.

And it doesn't have any of the $700 billion the administration is seeking to soak up the bad mortgage-backed securities that have been at the heart of the severe credit crisis the country has been struggling with since August 2007. The legislation Congress passed this summer that gave the authority to rescue Fannie and Freddie boosted the limit on the national debt by $800 billion to $10.6 trillion.

Frankly, writing about the financial scene right now is trivially easy -- any number of sage saying will ring true. But, writing is also pointless, as the flood of diatribe might entertain us, but does nothing to take us forward.

Well, maybe it's the grief thing: we need this time to wail and gnash over lost innocence and easy profits. We seem to be in the bargaining phase, as Ben Bernanke and Henry Paulson tell various leaders, great and good, to move forward, sign the (blank) cheque and accept the master you all know you need.

In an ideal world, we could skip the depression and move onto acceptance, and rebuilding. How to rebuild? The answer to that question requires a very deep understanding of what is wrong, first and foremost. As I described earlier, I believe the failure syndrome is one of an overly complex system, in which each component works in isolation, but is too complex to analyse externally. Especially, building upwards on this shaky foundation is not safe, but continues nonetheless.

(If, by way of your example, you believe the problem is something else, you are not going to subscribe to the following. That's ok, because in the blogosphere, we still retain a free market in ideas, if little else.)

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Onwards. Financial cryptography exists to reduce that complexity. One of the emerging results of financial cryptography, in all its various guises, is that the simple component is the stronger one, and the only sound basis for building to the next layer. We can build higher if we aggressively simplify the lower layers.

Let's present an example, one from Ricardo, which isn't the only system to employ these strategies, just the one I did and therefore is easier to present (another is Lynn's x9.59).

In this system, we use a thing called triple entry bookkeeping, which is digitally signed transactions stored in three places: yours, mine and the repository. Because the transactions are digitally signed and because there are 3 independently administered copies, and because all are equivalent (students of digital evidence take note) there is a very strong foundation on which to build the next layer. It might not be the best way to do transactions, per se (all those extra copies! all that superflous crypto-cycling! no two-phase commits!) but it does present the strongest foundation known to the upper layers.

So much so, that triple entry does for external accounting what double entry did for internal accounting 700 years ago. It is for reasons like this that designs like Ricardo will eventually change the financial system: they create building blocks that can be built on, and will support a massive weight, unlike the the current benchmark of cinder blocks of reinforced air.

When this system was presented to the SEC, someone at the meeting called it the third rail, which is finance-geek talk for the silver bullet. Ben Bernanke probably won't remember (he was there), but the point of this sophistication is an aggressive simplification: by knowing we can rely on every transaction being solidly recorded, we can move up to the next layer. Which we did; the whole system was really intended to resolve many of the uncertainties in today's trading, not just the lower layer accounting.

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Which then raises the real question: why the innovations in FC (the above one, and for further example, the so-called blinding formula and its three orders of cost-reduction, or naked transactions de-risking strategies, or ...) did not move forward? I believe the answer is found, again, in the complexity of each incumbent building block.

Incumbents favour complexity. More complexity means more jobs, which finds more favour. Complexity means that while it takes a long time to learn it all, once you get there, you are safer. It requires extraordinary minds to understand it all, and that makes you feel good about yourself, and helps you to lord it over the rest. It gives plenty of flexibility to deliver complex claims, and cover them up when they go wrong.

In fact, it is rather hard to find a good reason not to make something complex. That's because all of these things are good for incumbents, and terrible for everyone else, and nobody asks anyone else. E.g., the customer or the taxpayer is never asked, always told, and always lied to. Every one of the great reasons for complexity is a cost, a priori, with no payback. Every little complexity helps in the long run to raise our own entrenched position, inside, and create a 'tax' on the paying classes. Otherwise we wouldn't promote it.

But what is worse is that complexity hides a greater sin: what we might call complexity fraud. When everything is a mess, nobody cares if someone is stealing the garbage. Nobody will likely notice, and if indeed you are noticed, they'll likely praise you for your help! Complexity fraud is the best fraud of all, because it is a long term cash flow, it looks legal, and anyone smart enough to spot it and understand it would probably join it rather than fight it.

For example, consider the rating agencies. They are supposed to warn of credit risks. They didn't (again), until it was too late (again). Why not? Because they are mandated. Ratings have to be done for many markets, which guarantees a steady flow of revenue as long as nobody upsets the apple cart. This might have seemed like a wise move once, but it can also be seen as a fraud born of complexity: if the complex markets are too hard to understand, then we can create a rating agency that is simple to interpret. Fine. On paper, we apparently simplified it, but in practice, we removed the observation from the real complexity, and put it across to a single number system, and we created a payout for a special person. The moment it is *mandated* then the rating agency kicks back and sucks at the teat, like everyone else, as it has absolutely no interest in upsetting its relationship with the companies that pay for their rating. (Students of incentives, take note.)

And, this is why there was not so much resistance to that early 2000s evil, Sarbanes-Oxley. As long as it was done to everyone equally, everyone made more money. Everyone who was asked, that is. Accounting doubled in size, so the auditors weren't complaining. Rules doubled, too, so the high-end complexity-crooks were happy. Large banks weren't complaining because it reduced the nibbling of the smaller banks. Democrats are always happy at more regulation. Republicans are always happy to promise a safe free market. Everyone was happy.

Who lost? The end-paying public of course. Sarbanes-Oxley was a bill to ravell fraud, but it was hopeless at unravelling. Rather than stopping Enrons, we got a rabbit-like plague of them; not directly because of Sarbanes-Oxley, but because we took our eye off of the systemic mess -- well identified in the early 2000s -- and created more complexity to hide the real problems.

Technology can help. FC can simplify things; but the leadership to put in simplifications instead of complications is strangely absent in Finance, and tech can not solve that. You might not agree that this is because of the forces I outline above; but I've yet to find another compelling explanation for this observation: simplification is rarely praised, but complexity finds many friends.

Posted by iang at September 21, 2008 03:31 PM | TrackBack