Home' Technology Review : November December 2007 Contents 42 FEATURE STORY
TECHNOLOGY REVIEW /
Before he was at RiskMetrics, Gregg Ber man created
commodity-trading systems at the Mint Investment Man-
agement Group. In the mid-1990s, he says, a good algo-
rithm might trade successfully for three or four years. But
the half-life of an algorithm s viability, he says, has been
coming down, as more quants join the markets, as comput-
ers get faster and able to crunch more data, and as more
data becomes available. Berman thinks two or three months
might be the limit now, and he expects it to drop.
For Richard Bookstaber, a quant who has managed
hedge funds and risk for companies like Salomon
Brothers and Morgan Stanley, the August downturn
proved that concerns he d long harbored were well founded.
Bookstaber was on the panel sponsored by the IAFE; in fact,
he is everywhere these days. His book A Demon of Our Own
Design, which appeared in April, was eight years in the mak-
ing, and it made some very prescient predictions.
Bookstaber is a quiet, thoughtful man, with sharp brown
eyes and an attentive look. He studied with Merton in the
1970s at MIT, where he got his doctorate in economics.
Today, he is very worried about the tools and the meth-
ods of the quants. In particular, he frets about complexity
and what he calls "tight coupling," an engineer s term for
systems in which small er rors
can compound quickly, as
they do in nuclear plants. The
quants tools, he feels, have
became so complicated that
they have escaped their cre-
ators. "We have gotten to the
point where even profession-
als may not understand the
instr uments," he says. This,
to Bookstaber, was perfectly
demonstrated this summer,
when the subprime trou-
bles touched o a reaction-
ary wave of selling in equities that would nominally seem
unrelated, or, as Wall Street puts it, "uncorrelated."
"Nobody knew that what happened in the subprime mar-
ket could a ect what was going on in the quant equity
funds," he says. "There s too much complexity, too much
derivative innovation. These are the brightest people in the
business. If it could happen to them, it could happen to any-
one. No one could have predicted the linkage."
Linkage is one of Bookstaber s favorite topics. He
believes that quants instr uments have "linked markets
together that wouldn t normally be linked," and that such
linkages are dangerous because they are unforeseen.
Berman and others I spoke to agreed with many of
Bookstaber s concerns. "The products are getting an order
of magnitude more complex," says Berman. "Things change
slightly, and get correlated where they weren t correlated
before." Or, as he put it a little less gnomically, "You can t
make it without understanding it, but you can buy it."
Beneath all this beats the great hope of the quants: namely,
that the nancial world can be understood through math.
They have tried to discover the underlying structures of
nancial markets, much as academics have unlocked the
mysteries of the physical world. The more quants learn,
however, the farther away a uni ed theory of nance seems.
Human behavior, as manifested in the nancial markets,
simply resists quanti cation, at least for now.
Emanuel Derman remembers dreaming of such a uni-
ed nancial theory in the early 1990s, a little after he had
made the leap from the university to the Street. But those
dreams, he says, are dead. Quantitative nance "super -
cially resembles physics," he says, "but the e cacy is very
di erent. In physics, you can do things to 10 signi cant
gures and get the right answer. In nance, you re lucky if
you can tell up from down."
So up was down and down was up this summer, and Book-
staber and others hope it is a warning that will be heeded,
rather than the beginning of a major systemic crisis.
And was subprime the canary in the mine? It was a ques-
tion the panelists and the audience who
showed up at Four World Financial Center
last August are only beginning to answer.
Leslie Rahl, for instance, cautiously told
me in a follow-up e-mail that it is "look-
ing more and more like the answer is yes."
Many signs have suggested so, from job
losses to a continuing credit drought to a
weakening dollar, but that history has not
yet been written.
As a prelude to the panel discussion,
Rahl asked the audience to predict
whether credit spreads would shrink or
widen in the coming months. She was
talking about the di erence between the price of a treasury
bond and the price of a riskier corporate bond, a standard
Wall Street gauge for the health of the economy. A widen-
ing credit spread is generally seen as a sign of uncertainty,
and a narrow spread as a sign of optimism.
"How many think spreads will widen?" she asked.
The hands of about half the smartest people on Wall
Street shot up.
"And how many think they ll narrow?"
The other half---equally smart---raised their hands.
"Well," she said. "That s what makes a market."
If they didn t know, nobody could.
Bryant Urstadt is a freelance writer based in New York. His work has
appeared in Harper s and Rolling Stone.
The more quants learn,
the farther away a
unified theory of
finance seems. Human
behavior, as manifested
in the financial markets,
simply resists quantifi-
cation, at least for now.
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