When Derivatives Go Bad

Abstract: Unlike the markets that produce goods and services, the derivatives market cannot write off products that have either soured or were too risky to begin with. The complexity of the derivatives market suggests that some degree of risk can be attributed to both chaos and emergence. This suggests that there should be a statistical expectation of securities of little to no value; even in the most efficient of markets. There is however a concern of bad actors using write offs to their advantage; in some nefarious capacity. This too is of course statistically expected. This is a clear conundrum; in that one concern creates issues for the other. This is observably a distressing issue; as it plays out in the business cycle. Funds are either coerced to keep securities of questionable value on their books or unload them onto some unexpecting competitor or client. This is in no ones interest; as the consequences are unfavorable for the marketplace in general as well as the bad actors. This conundrum likely contributes substantially to the severity of consequences in the business cycle itself. When the overarching crisis cycle plays out to it’s end, such things are written off just the same; in order to recover a collapsed economy. It’s not as though it’s an absolute that bad securities do not get written off. They do; just under more severe conditions and by those who initially intended to regulate the marketplace. It’s a difficult and distressing problem for everyone; and one that demands some very careful consideration. Securities of no value:

Securities that have no value are just as large an issue for investment firms as produce that has gone bad is for the grocers. Grocers however are not expected to store bad produce indefinitely. It’s clear that this assertion bares some inequivalence; however the outcomes in the marketplace for keeping securities that do not produce returns are generally unfavorable. Initially, this puts added pressure on the firms; that is likely to have a negative effect on their feduciary responsibilities, under the most normal levels of uncertainty. This is a scenario that should be expected to worsen; as the number of valueless securities increases over time.

As these firms are composed of bounded agents, there is a degree of expectation that valueless securities are as enevitable as they are unfavorable. The complexity of the marketplace alone suggests this very strongly. There should be an expectation of risk no matter how competently and responsibly the before mentioned bounded agents behave. Even in the unlikely absence of bad actors, this is a scenario that should still be expected to deteriorate the marketplace over time. The only difference that should be expected when the market deteriorates into dysfunction, is that it occurs in a larger window of time. This suggests a need for a more generalized risk management assessment; under all conditions.

Chaos and Emergence:

The complexity of the derivatives market is beyond what is humanly tractable. Statistical analysis is thus employed to manage the complexity. Both chaos and emergence are expected in such a complex system.

Chaos:

Partnerships and supply chains are both examples of mechanisms in which chaos should be expected to propagate. It’s this evidence of integration in the system that promotes the expectation. In complex systems, discrete interactions can have far reaching effects; that can compound as they propagate. The initial conditions cannot be fully known by bounded agents; thus the appearance of chaotic behaviors should be expected. The integration between the derivatives market and all other markets should be expected to, and is observed to demonstrate chaotic effects as well. Deterioration of the derivatives market is truly, generally unfavorable.

Emergence:

A combination of the complexity of the derivatives market and the bounded agents that compose it suggest that surprising effects are to be expected. The bounded agents cannot of course be expected to be entirely aware of all aspects of and interactions within the marketplace. This promotes an expectation of the emergence of valueless securities; under all conditions.

Exploitative Agents:

There are a number of behavioral studies where game theoretical models were observed in the behaviors of species; throughout the diversity. This included the entire spectrum; from the simplest to the most complex. In all cases there was evidence of behavioral predispositions to manage instances of exploitation; in a symbiotic sense. This suggests that though symbiosis is normative, exploitation is to be expected in the interactions. There is also an expectation that the normative, symbiotic influence should be making corrections for much of it. This is after all the nature of living systems.

In the derivatives market there appears to be an elevated degree of competition. Initially, this puts added pressure on the bounded agents that comprise it. This may result in added feelings of desperation; and thus desperate behaviors. One might expect that there would be added instances of exploitation in the derivatives market as a result. This would be a clear concern where both mistakes and exploits could just be written off.

There are observations in business culture of one agent choosing a questionable strategy to gain an advantage; and others adopting the same strategy in order to compete. Given these observations, when an exploitative strategy occurs, one might expect that the strategy be adopted by the community as a whole. This would be consistent with reports of mania in economic studies. Concerns that writeoffs could be utilized in instances of exploitative mania is a real and serious concern.

The Crisis Cycle:

Crises have been observed to compound over extended amounts of time; to the near total collapse of economies. At such a point bad investments are written off; in an effort to recover the collapsed economy. This suggests that valueless securities are to eventually be written off; just the same.

A concern in the dynamics of the situation is that the valueless securities are one of the influences in the collapse of the economy. Work toward crisis management and prevention should thus address this issue; and put fourth a serious effort to solve it. The serious consequences of the lack of it fall on everyone. The higher the level of inquiry, the more serious this issue appears to be. This issue, by it’s chaotic effects, aids in the formation of crises.