An article gets the gist of risk backwards:
Passing Risk Onto Those Who Can't Manage It. Salon is reviewing two books that look at the concept of "risk management" on Wall Street. Basically, the suggestion is that "risk management" is what happens when people who understand risk much better pass the risk onto those who don't understand it at all. That's all that most complex financial instruments are really doing - wrapping up risk in ways that the buyers don't understand what's really happening. In some cases, this is considered fraud, as it was 300 years ago in the story covered in The Secret History of the South Sea Bubble, which recounts how the same process of passing on risk worked in the past. These days, however, the swindlers are apparently running the show, which is the story covered by Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, showing how derivatives traders are creating impossibly complex products, that they know no one can understand. As the review points out, the scary part isn't how many people are taken in by all this - but how it's still going strong. Risk is continuously passed around - and it's usually heading in the direction of those least likely to understand it. And, as much as you pass stuff around, "somebody winds up holding the hot potato when the music stops." [Techdirt]
The article criticises the unbundling and distribution of risk on two counts:
- The distance between where the risk physically originates and its eventual owner
- The complexity of derivatives products
The first point is an issue of information arbitrage. Information about underlying risk isn't evenly distributed. Original sellers seek to offset exposure they can't physically hedge. Traders have overlapping preferences given their positions, based on differing perceptions of risk over time. Each acts based on what they believe to be superior information. It is a stretch to say that eventual holders have bought with worse information than original sellers -- they compensate for less information about physical conditions through superior intelligence and modelling. And by the time the risk is priced for the eventual buyer, the spread of prices has squeezed leaving less price risk. Acquiring information comes at a cost, and those furthest from the origin of the risk make the greatest investment to gain it.
The quest for information arbitrage to make up for distance from origination also yields complexity. When risk is passed around -- its actually heading in the direction of those who understand and make a living off its complexity.
What does it all add up to? In a worst-case scenario: quite a bit of trouble. In the long run, "risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for. As government for the most part looks the other way, the stability of the financial markets is increasingly an illusion. In the last decade alone, the markets have come closer than most people realize to collapsing. Unless serious steps are taken to change the status quo, disaster could be imminent. We haven't seen the last of the bubbles, by any stretch of the imagination. We seem, in fact, to be addicted to them.
Actually the beauty of risk is that it isn't a zero-sum game in one respect. The market learns from its mistakes. Every time there is a catastrophe that models hadn't predicted (thinking a fat tail in a probability distribution was a skinny tail) -- that risk can be modelled, the market gains trust the risk is resolved and liquidity skyrockets as a result.