THE NEXT FINANCIAL CRISIS WON´T COME FROM A "KNOWN UNKNOWN" / THE FINANCIAL TIMES OP EDITORIAL

The next financial crisis won’t come from a ‘known unknown’

It is the unexpected interaction of different forces that can be dangerous in the financial system

Robin Wigglesworth


Sir Isaac Newton’s misfortune following his decision to sell shares in the South Sea Company in 1720 shows how even history’s most brilliant minds can fail to spot financial excess © Getty


Almost 300 years ago, one of the smartest ever humans did something very stupid.

In the spring of 1720 Sir Isaac Newton ditched his shares in the South Sea Company, which had been a granted a monopoly on British trade with South America, for a cool 100 per cent profit of £7,000. However, the stock kept climbing and Sir Isaac bought them back at almost three times the price he initially paid. Within months the bubble had burst, obliterating the scientist’s life savings and leading him to lament that he “could calculate the motions of the heavenly bodies but not the madness of people”.

With the 10th anniversary of the global financial crisis approaching, it is natural to attempt to guess where the next debacle will occur. Sir Isaac’s misfortune shows how even history’s most brilliant minds can fail to spot financial excess — aside from his scientific renown, he was also head of the Royal Mint at the time of the South Sea Bubble.

There are of course exceptions, but most prophets are usually little more than professional doomsayers, forever warning of a crash and claiming clairvoyance when one eventually occurs — much like a broken watch is right twice a day. It is also important to remember that crises of the scale of 2008-09 are exceptionally rare.

Some contenders seem obvious: Countries and companies have continued to pile on more debt, and central banks are beginning to withdraw their monetary stimulus. China’s economic slowdown could accelerate into a collapse. European politics still looks risky. Trade tensions might escalate into a full global trade war.

But these are all “known unknowns”, and true financial shocks tend to be something unforeseen, caused by disparate factors interacting in unpredictable ways, and exacerbated because of siloed understanding.

Think of the last crisis. Property experts could see there was a housing bubble — in fact prices peaked in 2006, well before the crisis erupted. But they didn’t appreciate how securitisation had revolutionised the loan market. Bankers and investors didn’t know — or care — how far underwriting standards had eroded, while policymakers were blind to how the financial economy could rip through the real one.

That is natural. The global economy is what scientists call a “complex system”, like a human brain, the ecosystem of the jungle, a nuclear plant or the entire physical universe. In fact, by directly or indirectly linking together every human on the planet in one network the economy is arguably the biggest and most intricate complex system we know about outside the world of physics.

But complex systems are hard to understand, and are inherently fragile. A series of small idiosyncratic failures can interact with each other and cascade into a catastrophe. For example, the Three Mile Island nuclear disaster in 1979 was caused by dodgy plumbing, a stuck valve and an ambiguous indicator light. So where are the dodgy valves, flickering indicators and blocked plumbing of the financial markets today?

To me, the most likely answer lies in the interaction between post-crisis regulation, tectonic shifts in the investment landscape, increasingly fragmented market infrastructure and the rise of algorithmic, automated trading strategies. In isolation, these are mostly positive developments, but combined they make markets more complex — and therefore dangerous.

Trillions of dollars have flowed from traditional mutual funds to passive ones like ETFs since the financial crisis. Trading is being stretched across an increasing number of competing venues. Banks have retreated from markets, to be replaced by tech-savvy but thinly-capitalised trading outfits. Citadel Securities alone accounts for one in every six trades in the US stock market, and other high-frequency traders account for another two.

Meanwhile, computer-powered “ quantitative” investors are ascendant, and increasingly set the tone for markets. Indeed, JPMorgan estimates that HFT, quants, passive funds and options now account for about 90 per cent of all US trading volumes. This trend is already advanced in the equity markets but is spreading in the fixed income universe as well. Glitches are already becoming more common, and a disastrous one looks inevitable.

It is always tempting to be Luddite and think that everything was better before. But that is the wrong response. This is no call to roll back post-crisis regulations, to undo the very real price improvements brought by high-frequency traders, or a denial of the huge savings brought by the passive investing revolution. Those are all genuine improvements.

The danger is in how these tectonic trends may rub against each other. It is hard to see this causing a 2008-style cataclysm, and any economic impact would probably be modest. But of all the potential financial earthquakes lurking out there, this is the least-appreciated.