{"id":26400,"date":"2017-09-15T18:00:11","date_gmt":"2017-09-15T18:00:11","guid":{"rendered":"https:\/\/themint.kinsta.cloud\/?p=26400"},"modified":"2020-08-01T19:37:03","modified_gmt":"2020-08-01T19:37:03","slug":"rick-bookstaber-interview-a-model-agent","status":"publish","type":"post","link":"https:\/\/www.themintmagazine.com\/rick-bookstaber-interview-a-model-agent\/","title":{"rendered":"Rick Bookstaber Interview: A model agent"},"content":{"rendered":"

Mainstream economics\u2019 failure to predict the 2008 crash undermined the profession\u2019s public credibility. There\u2019s a new game in town that financial risk guru, Rick Bookstaber, has faith in. He shares his belief.<\/strong><\/p>\n

Her Majesty Queen Elizabeth\u00a0 spoke possibly for the entire country when she\u00a0 famously\u00a0 expressed her disbelief in how the economics profession failed to see the banking crash a decade\u00a0 ago.<\/p>\n

Others did predict it but went unheeded. And while a repeat is oft predicted, there remains no way to see it coming. There may, however be something on the horizon.<\/p>\n

Nearly 15 years before the events of 2008, \u201cone of Wall Street\u2019s rocket scientists,\u201d Rick Bookstaber, first encountered an emergent approach to behaviour modelling that had promise. In 1993 Bookstaber \u2013 then head of risk management at Morgan Stanley – was introduced to so-called agent-based modelling at a conference in Santa Fe. He maintains that agent-based modelling provides something closer to the reality in financial markets than anything coming out of existing modelling\u00a0 approaches.<\/p>\n

The approach, now commonly applied in traffic management design, resonated with his observations of the car crash that was the 1987 financial crisis: \u201cOnce I saw agent based modelling it really struck a chord for me because I had been in the middle of the 1987 crisis. I was doing portfolio insurance and I saw the process and the dynamic as it occurred.<\/p>\n

\u201cI realised people don\u2019t optimise. There are different people doing different things, they came into the market with different time frames. It was much more the way a traffic flow turns into a traffic jam.\u201d<\/p>\n

He says he \u201cplayed around building little agent based models, using C programming,\u201d before letting it go. But he continued to be aware that \u201csomething was missing with standard methods.\u201d His realisation of the potential power inagent based modelling to reveal the vulnerabilities in a market was at least part of Bookstaber\u2019s rise to guru status in market risk management.<\/p>\n

His recent book in which he expounds
\n\u00a0\u00a0the potential of agent based modelling in financial markets is titled The end of theory. But its subtitle: financial crisis, the failure of economics, and the sweep of human interaction, arguably conveys more of its intent.<\/p>\n

He says he was particularly drawn to the shortfall in conventional modelling when considering the cascade in liquidity he has subsequently highlighted as a characteristic of crisis. That freefall in liquidity, as leveraged players sell in response to a shock, was apparent again, Bookstaber says, during the failure of Long Term Capital Management in 1998 while he was at Salomon. \u201cAnd there\u2019s the same story; they were highly leveraged and a shock to the market forced them to liquidate. That liquidation led to a drop in liquidity as people were waiting to see what\u2019s going on,\u201d he says.<\/p>\n

\u201cThe agent based approach and the dynamic that you facilitate with agent based modelling was apparent to me. I more and more realised this was a way to deal with financial crises.\u201d<\/p>\n

\n

\u00a0\u201cHe continued<\/strong> to be aware<\/strong> that \u2018something<\/strong>\u00a0<\/strong>was missing\u00a0<\/strong>with standard<\/strong> methods<\/strong>\u2019.\u201d<\/p>\n<\/blockquote>\n

\u00a0Bookstaber has played prominent roles in both the private sector and pubic sector with chief risk officer roles on the buy-side at Moore Capital and Bridgewater, and on the sell-side at Morgan Stanley and Salomon. Over six years to 2015 he was Senior Policy Advisor to the Financial Stability\u00a0 Oversight\u00a0 Council,\u00a0 and\u00a0 then joined the Department of Treasury in the Office of Financial Research, where he developed an agent-based model to assess systemic financial vulnerabilities. He is currently chief risk officer for the University of California\u2019s $100 billion pension and endowment portfolio.<\/p>\n

The Challenger<\/div>
Agent based modelling boils down to an expression of the dynamic interactions between agents in an environment whereby those interactions alter the environment.<\/p>\n

So agents \u2013 none of whom have sight of the entire environment they are in \u2013 see what others do and react and that changes the environment.<\/p>\n

This doubly dynamic process is fundamentally a representation of George Soros\u2019 reflexivity.<\/p>\n

Bookstaber describes four dominant influences at play in a financial market in crisis which he has playfully dubbed \u201cthe four horsemen of theeconopocalypse.\u201d<\/p>\n

They are: \u25a0\u2002 Computational irreducibility\u00a0 \u2013 interactive processes that can\u2019t be simplified through mathematical formulae \u25a0\u2002 Emergentphenomena \u2013 changes in the environment to which agents react \u25a0\u2002 Non-ergodicity \u2013 agents change in line with their experiences \u25a0\u2002Radical uncertainty \u2013 we create and change our world in ways agents can\u2019t anticipate He asserts that conventional economics cannot \u00a0 accommodate any of these because it is based on assumptions of uniformity and deductibility that run counter to each element.<\/p>\n

Agent based modelling can accommodate all of them because its components are heterogenous and responsive in the immediate and long terms.<\/p>\n

Bookstaber maintains that the behaviour of financial markets cannot be modelled as if they obeyed mathematical laws: \u201cMarkets are systems based on gaining an informational advantage, on gaming, on action and strategic reaction, and thus a space that can never beexpressed with a fully\u2013specified model or with well\u2013delineated possibilities.\u201d<\/p>\n

He emphasises that no meaningful analysis of a market \u2013 particularly a market approaching or in crisis \u2013 can assume away complexity and imprecision. Agent based modelling encompasses them, he says, and offers \u201ca different angle of attack.\u201d<\/p>\n

And it offers regulators \u201ca fighting chance of usefully modelling the course of a financial crisis.\u201d Furthermore Bookstaber says agent based modelling may inform beyond crises into risk in business as usual. <\/div><\/div>\n

His move from private sector high flyer to regulation and research was, he says, a \u201csacrifice\u201d but he had profound ambitions: \u201cI really wanted to do it because in I had sort of sketched out how leverage and liquidity could lead to the crisis. Then it occurred.\u201d<\/p>\n

And his counsel and books are highly regarded: \u201cI had given testimony five different times about what needed to be done and why we\u2019re having these problems.<\/p>\n

\u201cI felt like if I didn\u2019t try the best I could to help reformulate the financial system, then I\u2019d be sitting around for the rest of my life like one of these old codgers saying: Well you know I remember and if they had just done this. So I felt like if I didn\u2019t do it I would just regret not having given my best shot.\u201d<\/p>\n

While at the Office of Financial Research, Bookstaber played an instrumental part in drawing up the Volcker Rule \u2013 an element of the Frank Dodd Wall Street Reform and Consumer Protection Act which says that bank dealers can\u2019t do proprietary trading when they\u2019re also client facing. It reduces the risk that bank dealers will disrupt the markets through proprietary trading. \u201cThere\u2019s an exception for [Volcker]\u00a0 \u2013 the market making exception which I was instrumental in pushing through,\u201d says Bookstaber.<\/p>\n

\u201cIf they couldn\u2019t do any sort of trading, then they couldn\u2019t make markets \u2013 and obviously you need to do that. And the various broker dealers piped in and said you can\u2019t put this in place because it\u2019ll really reduce liquidity in the market. And of course people in Washington were sceptical of that, they said yeah, yeah sure, whatever. But because I\u2019ve been on the other side, I said no you really have to have this in place.<\/p>\n

\u201cSo we got the market making exception and I proposed various metrics that could make sure, or hope to make sure that the client-facing trading desks were indeed\u00a0trading to the benefit of clients and weren\u2019t doing proprietary trading on the side.\u201d<\/p>\n

It was three years into his time at the Office of Financial Research when he returned his sights on agent based modelling because \u201cwe had to have a way of assessing vulnerabilities in the financial system and that was the tool to use.\u201d<\/p>\n

\n

\u00a0\u201cI had given testimony<\/strong> five<\/strong>\u00a0<\/strong>times\u00a0about<\/strong> what needed<\/strong>\u00a0<\/strong>to be done<\/strong> and why<\/strong> we\u2019re having<\/strong> problems<\/strong>.\u201d<\/p>\n<\/blockquote>\n

\u00a0But the US is still yet to adopt the approach. \u201cI was sort of a lone voice in the wilderness, so I got a lot done. But the dominant player in anything having to do with this type of systemic regulation is the Federal Reserve. Treasury is more like a central switching station for all the different regulatory agencies; they don\u2019t actually do regulation themselves, interestingly enough. And the Fed, has enough PhD economists to staff probably ten universities.They\u2019re very wedded to the standard approaches.<\/p>\n

\u201cSo the real application of agent based modelling, it really is more occurring in Europe, than in the US.\u201d<\/p>\n

Bookstaber says the Bank of England is a leader. He says the OECD too is \u201cinterested in these alternative approached to standard economics,\u201d and he recently gave a talk to the organisation in Paris where he introduced the agent based approach.<\/p>\n

\u201cIf you just look around at the people who are writing in this field, they\u2019re from Italy, from France, Spain, all over Europe. And actually even the Americans \u2013 most of them have moved to the Institute for New Economic Thinking.<\/p>\n

\u201cI think the reason is that the US is the bastion of neo-classical economics. Everybody has human capital tied into and to suddenly walk away and start agent based modelling is to walk away from your investments in your human capital \u2013 all the students that you have who now are writing things to support your theories and so on.<\/p>\n

\u201cWhereas in Europe, I don\u2019t feel like there was ever quite the dogmatic acceptance of neo-classical; it was a little more of a free for all and so it\u2019s easier for people to adapt a new approach. In the OECD it seems like they have a little more freedom to try something new because they\u2019re not so wedded to the old approach. Whereas the Federal Reserve is probably just about the last place that can do it in any real way.\u201d<\/p>\n

Cultural hurdles have been the focus of much of the criticism of the sector post 2008. While the regulators too have been the target of criticism for weakness in allowing excessive high risk taking that is commonly perceived as beingcentral to the crisis, the culture and values in banking are seen by many as in need of change to avoid a repeat of the crash. Bookstaber is emphatic in his response: \u201cThe notion that you\u2019ll change the culture I think is sort of a fool\u2019s errand, I just can\u2019t see that happening. The people who go into finance are self-selected and they\u2019re not exactly the Mother Theresa\u2019s of the world. It\u2019s not like they\u2019re venal but they\u2019re driven by a profit motive.\u201d<\/p>\n

\n

\u00a0\u201cThe notio<\/strong>n <\/strong>that you\u2019ll<\/strong> change<\/strong> the culture<\/strong> is sort<\/strong> of a fool\u2019s<\/strong> errand<\/strong>.\u201d<\/p>\n<\/blockquote>\n

Bookstaber, in The end of Theory, posits that complexity is fundamental to the tactics and strategies in markets much as it is in military practice. And increase\u00a0complexity, he says, takes the financial markets beyond the capacity of currently accepted economics theory to respond.<\/p>\n

He says that markets, like the military, stretch complexity beyond even the notion of reflexivity notably highlighted by star investor, George Soros. In a reflexive market, values are based on subjective understanding, not objective reality.<\/p>\n

Complexity is compounded because subjective interpretations in the market affect actual values which in turn feed further subjectivity. Bookstaber says markets go a stage further. He holds up what he refers to as strategic complexity, \u201cwhere people deliberately try to create complexity in the system to gain an advantage in that system.<\/p>\n

\u201cIn the military, that\u2019s the game. And I give examples of that in the book. There\u2019s a famous military strategist, John Boyd in\u00a0 the US, who\u2019s objective was to create an environment that was unstable with the respect to the adversary. That way you could react more quickly than they \u00a0could because you knew the complexity you were throwing into thesystem and they didn\u2019t.<\/p>\n

So it may not be quite as bad as warfare, but there certainly is a component of strategic complexity in the financial system.<\/p>\n

\u201cRegulation\u2019s<\/strong> never<\/strong> going to be perfect<\/strong> and people<\/strong> will always<\/strong> game around<\/strong>\u00a0it”<\/p><\/blockquote>\n

\u201cYou think of people trying to operate in markets more quickly, you think of the creation of more complex instruments, creating situations where you have differential information because, say, you\u2019re a market maker. All those things help you create this strategic complexity.\u201d<\/p>\n

In this environment, Bookstaber says, \u201cthere\u2019s going to be people finding ways to alter the environment to their advantage,\u201d and furthermore \u201cthe regulators are always gonna be behind the game because it takes so long to discover what\u2019s happened and to put a regulation in place.\u201d Bookstaber adds: \u201cWhat regulation was necessary or could have helped stem the crisis in \u201808,\u201d but he says he knows no alternative to regulation.<\/p>\n

\n

\u00a0\u201cWhat regulation<\/strong> was necessary<\/strong> or could<\/strong> have\u00a0helped<\/strong> stem<\/strong> the crisis<\/strong>?\u201d<\/p>\n<\/blockquote>\n

\u201cReducing complexity and reducing leverage, it just wasn\u2019t that hard to do. We just didn\u2019t see it ahead of time and actually we did the opposite. We made the markets freer. What do we need now? Something that helps facilitate liquidity, I thinkthat\u2019s one of the big issues currently.\u201d<\/p>\n

Bookstaber does advocate splitting up the banks but says simply making more, smaller entities would be a waste of time. He explains that banks occupy the three chief layers of the finance world: markets, funders and collateral \u2013 central counterparties supporting funding. While banks of any size remain in all three layers there will always be a likelihood that a shock to any layer will lead to contagion.<\/p>\n

Meanwhile the issue remains that regulators are left as effectively moral guardians of a sector where ethical behaviour is rarely seen as part of the job description. Is that the best we can expect? \u201cI think it\u2019s more that regulation\u2019s never going to be perfect and people will always game around it. But regulation has to do the best job it can; it has to be thoughtful.<\/p>\n

\u201cYou think of people trying to operate in markets more quickly, you think of the creation of more complex instruments, creating situations where you have differential information because, say, you\u2019re a market maker. All those things help you create this strategic complexity.\u201d<\/p>\n

\u201cIt has to try to anticipate what people might be doing but realise that, the best thing a regulator could do is be able toact more quickly and not be so regimented in\u00a0what they do because the more tightly defined the regulations are and the more slowly they come into place, the easierit is to find ways around it,\u201d says Bookstaber.<\/p>\n

\n

\u201cThere is a difference<\/strong> in culture<\/strong> from one<\/strong> institution<\/strong>\u00a0<\/strong>to the other<\/strong>.\u201d<\/p>\n<\/blockquote>\n

\u00a0While he sees an alignment in the financial sector with the greater good as desirable, Bookstaber makes the pointthat the fundamental driver for the sector \u2013 to make returns \u2013 is not conducive to a focus on the greater good. He says,however, that his sector-spanning career path has revealed differences between different segments of the industry.<\/p>\n

\u201cI think it is true, actually that there is a difference in culture from one institution to the other. Some will simply not do something, even if they could get away with it, because it\u2019s just wrong,\u201d he says adding: \u201cI don\u2019t want to name institutions specifically, but I think if you go through my book, it\u2019s pretty apparent that there\u2019s some that simply didn\u2019t have a sense of decency over profit.\u201d<\/p>\n

While he names no institutions he is clear about where the decency is most abundant: \u201cIf you go from the banks to the investment management firms to the hedge funds to the sovereign wealth and big pension funds, I think that afocus on the common good tends to exist more in the last two of the group. In fact a lot of them have mission statements that extend beyond generating returns.<\/p>\n

Furthermore, he sees a role within a return-making primary motivation, for the pension funds and sovereign wealthfunds to act for the common good Bookstaber says pension funds and sovereign wealth funds are well positioned toprovide protection in a time of financial crisis as a buyer of last resort \u2013 rather than the government which he sees as likely to act too slowly and always burdened with political considerations. He says those funds, \u201carmed with agent based modelling so they can understand the dynamics that are occurring,\u201d could use their position of holding lots of capital and being unleveraged with long holding periods, to go into markets that are under extreme pressure as liquidity suppliers.<\/p>\n

Bookstaber explains: \u201cSo if a market is down 30% because people have to sell. And agents are being forced to sell and other agents\u00a0 who\u00a0 normally\u00a0 supply\u00a0 liquidity\u00a0 are not doing it, then I [a pension fund] will take one-tenth or whatever of 1% of my capital and go into that market and buy when it\u2019s 30%\u00a0 down.\u00a0 And\u00a0 because\u00a0 I\u2019m\u00a0 buying \u00a0when it\u2019s 30% down, I\u2019m supporting the price so it doesn\u2019t go down 40%. And finally the dust settles, I\u2019ve helped dampen the path of the crisis and things\u00a0 go back up to close to normal and I\u2019ve made 30%. So that\u2019s a case where you can have decency and if you had a mission statement that includes market stability, you could be adding value to the market and making returns as you do \u00a0so.\u201d<\/p>\n

\n

\u00a0\u201cThe best<\/strong> thing<\/strong> a\u00a0regulator<\/strong>\u00a0<\/strong>could do<\/strong> is be able to act<\/strong> more\u00a0quickly<\/strong>.\u201d<\/p>\n<\/blockquote>\n

\u00a0Were agent based modelling to prove itself to be a model that warrants confidence, has it then the potential to help shield the world from the impact of financial meltdown in ways that economics has failed to do? \u201cUltimately, I\u2019m looking at agent based modelling not just as a new paradigm,\u201d says Bookstaber. \u201cAnd I really feel that it\u2019s not just another model. I feel that it really is a new paradigm of a way to look at economic man, as economic human.\u201d<\/p>\n","protected":false},"excerpt":{"rendered":"

Mainstream economics\u2019 failure to predict the 2008 crash undermined the profession\u2019s public credibility. There\u2019s a new game in town that financial risk guru, Rick Bookstaber, has faith in. He shares … <\/p>\n","protected":false},"author":1,"featured_media":26388,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"content-type":"","footnotes":""},"categories":[54,58,2,47],"tags":[336,132,871,1551,130,256,207],"class_list":["post-26400","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-finance-sector","category-government","category-interviews","category-north-america","tag-agent-based-modelling","tag-economics","tag-game-theory","tag-gaming-regulation","tag-regulation","tag-rick-bookstaber","tag-sept-2017"],"acf":[],"_links":{"self":[{"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/posts\/26400","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/comments?post=26400"}],"version-history":[{"count":0,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/posts\/26400\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/media\/26388"}],"wp:attachment":[{"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/media?parent=26400"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/categories?post=26400"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.themintmagazine.com\/wp-json\/wp\/v2\/tags?post=26400"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}