Now gold is another dataset in the complex algorithm that shapes the prices and trades of the global financial system and consequently influences the policy decisions of nations and the flows of investment capital. In this post, I examine some of the recent historical threads of risk analysis and their relationship to computerized trading and the formation of a global “Information Standard” [2].

Risk has always been a factor in investing and lending, whether investing cattle in a sailing expedition to the Spice Islands or British pounds in a transcontinental railroad in the Americas. Captains and merchant ship owners knew that Edward Lloyd’s coffeehouse was the place to go for marine insurance and shipping news. That was the start of Lloyd’s of London, one of the most storied insurance companies in risk history. Certainly the “tulip mania” of 1630s Amsterdam is part of our lexicon of financial bubbles and risk, even getting a short cameo and description by Gordon Gekko in Oliver Stone’s Wall Street: Money Never Sleeps. Risk emerged a more predominant factor in the 1970s when a series of events and innovations occurred in the interconnected areas of international finance, news, and telecommunications.

The New Deal started an era of financial containment, but it couldn’t withstand the stresses of globalization and the rise of new technologies. In addition to legislation like the Glass-Steagall Act of 1933, which kept investment banks from gambling with depositor’s money, FDR confiscated all gold used for currency and built Fort Knox in Kentucky during the mid-1930s to keep it out of the hands of the Nazis. The Allies used these bullion stores at the end of World War II as the basis of a new international economy by tying the dollar to gold at $35/oz (28.35 grams) and the monies of other Allies to the dollar. This experiment, organized in July 1944 when the United Nations Monetary and Financial Conference was held in Bretton Woods, New Hampshire, ran counter to US policy and was destined to failure. When Nixon ended the arrangement in August of 1971, it introduced unprecedented levels of volatility and volume into the global economy. The end of the Bretton Woods agreement was in part at blame for the two oil crises of the 1970s and the raging inflation that plagued the decade.

This new era of floating exchange rates was characterized by a new virtualization of foreign exchange (F/X) trading through interbank spot markets, facilitated largely by Reuter’s new Monitor Money Rates that displayed prices of currencies from banks around the world. Recognizing the need for new F/X risk management techniques, currency futures were introduced at an offshoot of the Chicago Mercantile Exchange (CME). On May 16, 1972, the International Monetary Market (IMM) was opened to provide future delivery of currencies at fixed prices. It initially traded contracts in seven currencies: the British pound, the Canadian dollar, the German deutsche mark, the French franc, the Japanese yen, the Swiss franc, and Mexican peso. Both currency markets received a financial boost in October of 1973 when several Arab states launched an attack on Israel, setting off further volatility in the currency markets, especially as oil production was cut back in response to international support for the Jewish nation-state.

A related process was the recirculation of eurodollars (US currency held outside the country), from OPEC countries to developing and Soviet countries. As almost all oil sales are denominated in US dollars, it created a surplus in devalued “petrodollars” which western banks lent out to OPEC countries like Argentina, Bolivia, New Zealand, Poland and South Korea. To reduce their exposure, several banks would come together to make a syndicated loan to a country like Brazil, with a leading bank taking a major position and several others sharing the risk. Propelled by the rhetoric that sovereign countries don’t go bankrupt, this financial bubble would have a dramatic effect on nations around the world.

The resultant “Third World Debt Crisis” changed the global landscape, forcing countries to sell off government assets and state-owned enterprises (SOEs) and pressuring countries to open their borders to unrestricted and unexamined flows of data and news. Many of these countries were transformed from developing countries into “emerging markets”, open to international flows of direct and portfolio investments and subject to increasing amounts of country risk analysis and examination. The term “Washington Consensus” gained circulation as a set of policy prescriptions involving fiscal discipline, liberalization of trade and the inflows of capital, privatization, tax reform, and the deregulation of a wide range of industries to allow competition and foreign ownership. Government PTT (Post, Telephone, and Telegraph) operations were liberalized and sold off opening the way for modernization including the World Wide Web. Debt was transformed into equity and traded on new electronic platforms around the world while US$3 trillion flowed daily through the global currency creating a new global sovereign power that could influence the policies of individual countries.

As this global environment emerged in the late 1980s and early 1990s, it manifested a new type of trading organization intent on utilizing computerized risk management and trading techniques. Called “hedge funds”, they aimed to combine high leverage with various types of arbitrage methods and pairs trading. The general strategy was based on the thesis that multiple risky positions taken together can effectively eliminate risk itself. One company in particular, Long Term Capital Management (LTCM) gathered together some of best financial minds to create the ultimate hedge fund. The payroll included Nobel Prize laureates Myron Scholes, half of the team that came up with the Black-Scholes algorithm for trading options and Robert C. Merton, who also received his prize for working on how to determine the value of derivatives. LTCM strove to take advantage of this new trading environment by using “dynamic hedging” to trade continuously and globally. They raised money from large investors and developed electronic trading systems that literally drew on a type of rocket science called “Ito calculus“, developed to guide a missile microsecond by microsecond. Their trading strategy was to use these computerized systems to continuously monitor and trade a combination of financial derivatives and securities globally, based on probability theories and risk management techniques.

While hugely successful at first, they ran into a series of geopolitical events. LTCM returned over US$2.5 billion to its investors in 1997. While indicating success, it also reduced their capital base, and consequently their ability to deal with volatility. LTCM ran into trouble during the Asian financial crisis in 1997 and especially in August 1998 when Russia defaulted on its government bond payments, losing over a half a billion dollars in a 24 hour period just three days later. Over-leveraged and under-capitalized, it lost over $4.5 billion in the course of a few months. With the entire financial system at stake, the New York Fed and several major financial institutions initiated a bailout. LTCM operated for a few more years before it was quietly disbanded.

The reputation of mathematical risk models took a hit with the fall of LTCM but they were by no means abandoned, especially after the Commodity Futures Modernization Act of 2000 further deregulated derivatives trading. The extraordinary surplus wealth that had been accumulating in the 20th century, along with new digital calculation and transaction methods that were recruited to make money in the financial markets, has intensified the complex of global data and trading activities that Wriston argued make up the global “Information Standard”. He was particularly intrigued with the power of computerized F/X trading that now exceeds $3 trillion a day. But the environment has since become increasingly complex as “quants” entered the equation with sophisticated algorithmic techniques to manage risk while trading a wide range of financial instruments for profit. Debt instruments in particular have been a focus of speculation and the sovereign bond market has become an additional gauge of national risk. This has become particularly evident in Europe where the euro has become a multinational currency, superceding the national economic policies of the so-called “PIIGS” (Portugal, Italy, Ireland, Greece, and Spain) countries. Having lost control of their currencies, their sovereign debt has become a focus of trading scrutiny.

Like the traditional Gold Standard, the Information Standard is no panacea for the management of the global economy. Both impose restrictions on national political structures and policy decision-making. Politicians like Republican Ron Paul want to go back to the Gold Standard, but powerful forces are invested in the current global system[3]. Also currency regimes are usually organized by dominant creditors and that status is moving from the US to China.

Risks are inherent in both value regimes but it is likely that the Information Standard is reflective of a complexity that is more inclusive of a wider group of participants and away from the government/big banker nexus that characterizes the economic organization around gold. But the trillions of dollars that are in play in the system continue to create a chaotic turbulence of both bubbles and innovation that are highly disruptive to established and more stationary routinized lives and political structures. That is why it will be interesting to see if China has the capability to impose a new order of managed exchange rates and flows of capital.

Notes

[1] Walter Wriston went to work for Citicorp after World War II and eventually become CEO in 1969. The son of a university president, Wriston was often noted for his knowledge of international relations and diplomacy and championed the recirculating OPEC dollars to developing countries as well as other technological innovations such as CDs and the ATM. The Tufts Digital Library contains the Walter Wriston Archives that holds many of his speeches and published articles.
[2] Much of the discussion on the Information Standard had been on its disciplining of nation-states as Wriston discussed in this The Twilight of Sovereignty: How the Information Revolution Is Transforming Our World. Wriston’s interpretation of the Information Standard is organized around a rhetoric of assurance, not a critical analysis. The power of multinational corporations, nation-state dictatorships, and any aggregation of power antithetical to democratic prospects will fall to the sovereign power of the information standard.
[3] The size of banks would have to be considered in evaluating whether the Information Standard has explanatory or analytical power. The credit crisis of 2007 and its remedies significantly increased the power of major banks.

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Anthony J. Pennings, PhD has been on the NYU faculty since 2001 teaching digital media, information systems management, and global communications. © ALL RIGHTS RESERVED

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