DWS GLOBAL FINANCIAL INSTITUTE. Your entry to in-depth knowledge in finance: Sociology in Finance Interview

Transcription

1 Your entry to in-depth knowledge in finance: Sociology in Finance Interview March 2012 Prof. Donald MacKenzie

2 2 PROF. DONALD MACKENZIE Professor of Sociology School of Social and Political Science University of Edinburgh Web Page: Click here DWS Global Financial Institute (DGFI): You are one of the leading authorities in research regarding the link where sociology meets finance. For the benefit of anyone who may be new to this topic, could you briefly explain the type of research you do and how it can be or has been practically applied? MacKenzie: One way of thinking about what I do is that I try to fill a big gap in the market intellectually. Most academic research in finance is by economists, who have made truly impressive advances, but who often base their work upon models that assume rational behaviour by market participants. The other main strand of research is behavioural economics, which has been inspired primarily by work in psychology. The biases in reasoning that this research identifies are very important, but crucially, they are typically understood as individual biases. fundamental way in the past 30 or 40 years. Would you agree, given the recent changes in regulations, global investor sentiment, global public opinion, etc., that these economic theories are on the verge of another fundamental change? MacKenzie: In my book, I basically explored the issue of the processes that take place when economic models stop being things that you simply find in lecture theatres and books, and start being employed by market participants. The main example I focused on was the Black-Scholes option pricing theory, which had significant effects on how market participants priced options. So you could say that the theory was, for a time, self-fulfilling. That stopped with the 1987 crash, and since then patterns of market prices systematically deviate from Black-Scholes, and that s what is commonly called volatility skew or smile. That leaves a huge terrain where there has been far too little research. Take for example the question of organisations. Most market participants don t work as isolated individuals: They are members of organisations, often large, complicated organisations. Anyone who has worked in such an organisation knows that organisational structures, office politics, turf wars, incentive structures, etc., profoundly shape people s behaviour. That s the kind of thing that interests me. DGFI: In your book An Engine, Not a Camera, you wrote about how the emergence of modern economic theories of finance has affected financial markets in a Clearly, what is going on at the moment is that there has been a great deal of criticism, some of it justified, of orthodox financial economics. In my view, the technical advances in that field are here to stay, but certainly could do with refinement, and we need to be careful not to read more into them than is justified. Consider, for example, the efficient market hypothesis. There s plenty of evidence that mainstream markets are pretty efficient in that it is hard to systematically earn excess risk-adjusted profits. But we shouldn t infer from this that markets always get it right, as some people were a little inclined to do prior to crisis. Plainly, they don t. Bubbles and crashes, for example, are real

3 3 phenomena, even if some orthodox models make it hard to see why they should happen. So my hope is that over the coming years, we ll see market theories evolve to become richer and more interdisciplinary. liquidate parts of their portfolios to meet those losses, those liquidations caused prices to move against them (and also against LTCM), and a disastrous spiral ensued. DGFI: Similarly, in your book Do Economists Make Markets?, you and your coauthors explain how economists affect markets by saying what markets are doing, should do, and will do, and that economics can be highly performative. Do you see any strong trends in the world of economics today that could become self-fulfilling prophecies tomorrow? MacKenzie: I ve not been following developments in financial economics very closely over the past two years, so I wouldn t be able to identify anything specific here. Nevertheless, I think it remains the case that any economic theory or model that is taken up widely by market participants can affect markets, both in a self-fulfilling manner, but also in a self-negating fashion. DGFI: You compared the financial theories behind the 1987 stock market crash with that behind the crisis following the Long-Term Capital Management collapse in How do the economic theories behind the financial crisis since 2008 compare with those two? What are some key similarities and differences? MacKenzie: The 1987 crash arguably involved an element of self-negation. Although the case has never been proven decisively, there is good reason to think that the crash was exacerbated by the widespread practice of portfolio insurance. This practice involved using Black-Scholes option theory to synthesize a put option, in other words setting a floor beneath which the value of a portfolio should not fall. The strategy unfortunately involved concerted selling, which led to wild price movements that were grotesquely unlikely on the so-called log-normal model underpinning Black-Scholes. Long-Term Capital Management was a rather different case, in that the key factor here was that LTCM s very successful relative value arbitrage strategies had been widely copied. The Russian default in the summer of 1998 caused losses to quite a number of the firms that had strategies similar to LTCM s. These firms started to The key difference between 2007 and 2008 and those two previous cases is the role played by credit ratings in the 2007 to 2008 case. I ve explored this in detail in an article in the American Journal of Sociology in May 2011, which is available on my website ( The role of models here was primarily in the ratings process for both mortgage-backed securities and for collateralised debt obligations built out of those securities. Market participants were well aware of the properties of these models indeed, in many cases the ratings agencies made them available for downloading. The models were widely arbitraged in the sense that this created an incentive for market participants to put together the riskiest and thus highest-yielding pools of assets that could nevertheless get the desired ratings. DGFI: In your essay The Five-Second Pause, you researched what causes market movements and volatil ity in the modern financial world of highly electronic and algorithmic trading. In your opinion, at what stage do human sentiments and behaviour, including confidence, uncertainty, and panic, move markets? MacKenzie: There s no doubt that in many markets (equities, futures, foreign exchange, etc.) a great deal of trading is now algorithmic, with big institutions using execution algorithms to break up large orders into small pieces, electronic market makers setting bid and offer prices, and statistical arbitrageurs looking for deviations from patterns of pricing and betting on those patterns reasserting themselves. Nevertheless, human sentiments still play an important role. Consider, for example, the notorious flash crash of May The trigger for that was a huge sale of index futures by an institutional investor using an execution algorithm, and the goal seems to have been to protect a portfolio from further losses. Thus fear, or at least uncertainty, played a role, one presumes, in informing that decision by the institutional investor. The dramatic drop in prices was also halted by human intervention. The Stop Loss Functionality of the Chicago Mercantile

4 4 Exchange s Globex system was triggered by the plunge in index futures prices, and it paused trading for five seconds. That was just enough time for human participants to check that nothing disastrous had actually happened, regain confidence, and re-enter the market, halting the plunge in prices. DGFI: You have also done research that links sociology to various other industries, such as information technology, nuclear weapons, the environment, and more. As a sociologist, what are some themes you see that strongly distinguish the world of finance from others? MacKenzie: One of the themes that strongly characterises the world of finance and is not as prominent in the other areas is what the hedge fund manager George Soros calls reflexivity. In my experience, market participants in finance are exquisitely sensitive to what others are doing, and spend a lot of time thinking about what they re doing and why they might be doing it. Although the financial markets are global and trading is largely anonymous, in other respects key markets can resemble a village. People know who the other big players in their market are, copy people who are successful, etc. This, for example, was central to the processes that led to the collapse of LTCM. There s a surprising amount of sharing of information, ideas for strategies, and more, amongst apparent competitors. So that intense village-like aspect of behaviour though you can find it in other areas as well is particularly strongly manifested in the financial markets.

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