By Simon Miller
In the wake of the financial crisis, commentators are still trying to find the answers to how it happened. Former head of advertising at UBS Mark Roeder was at the forefront of the crisis as it engulfed the Swiss bank. In his book, The Big Mo, Roeder argues that the world in general, and the financial markets in particular, are suffering from what he calls “The Big Momentum”. In this interview, he sets out why momentum exists and how finance houses should be aware of the risks involved.
To start, tell us a bit about yourself?
I was born in London, grew up in Australia, and these days divide my time between Zurich and Sydney. I have spent most of my career working for large financial institutions such as Westpac bank, Zurich Financial Services and UBS bank, in places like New York, London, Sydney and Zurich. My speciality is global brand and communications strategy, which is critical for financial companies to get right because they are selling ‘intangible’ products where perception is reality. So, reputational risk is a big issue.
How long were you at UBS?
I was at UBS from 2004 to the beginning of 2009.
What, in your words, is momentum?
I think of momentum in a behavioural sense. That is, I’m interested in why
people act together in a similar fashion, en masse, regardless of the consequences. This behavioural momentum has become very powerful in recent years, driven by advances in technology, market integration and communications media, which speeds up the flow of events — not just in the financial markets but across every dimension of our world. Momentum is the new Zeitgeist. Very large scale behavioural momentum is known as The Big Mo.
In the introduction of the book, you say that momentum is different to herd mentality. Can it be argued that herd mentality is a symptom of this momentum, ie: momentum is manifested through herd behaviour?
Herd mentality has always been with us. From an evolutionary perspective, it helped our ancestors to flee a great threat or fight a tribal war. It’s a collective manifestation the ‘fight or flight’ syndrome. What’s different today is that this innate herd behaviour is being magnified to such an extent, that it can destroy an entire system – which is what we saw with the global financial crisis. The interconnectedness and speed of the modern financial system, together with the sheer scale of money flowing through it, ensures that any perturbation in the system can quickly spiral out of control. Consider the example of automated trading technologies, which make thousands of transactions a second, and now account for nearly 70 per cent of all equity trades. Such trading systems caused the Dow Jones Index to drop almost a thousand points in 20 minutes last May, temporarily wiping out $1 trillion (£0.6 trillion) in value in what has become known as the ‘flash crash’. The next generation of automated trading systems will operate in ‘picoseconds’ – that’s one trillionth of a second — enabling speculators to operate at lightning speed. The cumulative impact of these developments is generating a powerful systemic momentum which is highly destabilising.
If the crisis was different to previous crashes being systemic rather
than herd, why did no-one change tack? Everyone kept going in the same direction.
What makes systemic momentum more dangerous than old fashioned herd momentum, is that it is much more difficult to detect. It’s not visibly reflected in the frenzied, herd like behaviour of those around us. Rather, it exists in the background infrastructure amid all those interconnected networks, humming away at instantaneous speeds, supported by mathematical models which convey the illusion of stability. The core problem is that, despite our 21st century technical prowess, we are not good at detecting systemic risks. We tend to think of the really big risks as emanating from the outside – such as a war, earthquake or pandemic – rather than from within a system itself. According to a 2006 report by the Federal Reserve Bank of New York and the US National Academy of Sciences, we don’t even know how to ‘define systemic risk because it lies outside any existing economic theory’. This inability to define or measure systemic risk explains why such a dangerous level of momentum was allowed to build up in the global financial system without it being detected, and why everyone kept going in the same direction. We also assume, misguidedly, that when things go haywire they will naturally return to a state of equilibrium. But the momentum effect can push a system to spiral completely out control until it collapses in on itself.
Could it be argued that the system collapsing is part of the equilibrium process in itself? That is to say that the collapse will result in an altered more balanced system and so equilibrium?
The trouble is that some systems cannot survive a ‘collapse’ so there is no state of equilibrium to return to. They are simply destroyed. We see this phenomenon increasingly in the natural environment where, say, a rainforest ecosystem is so severely damaged that it cannot regenerate itself. The more complex and interconnected a system becomes the more fragile and vulnerable it is to systemic collapse. Unfortunately, the global financial system has now reached this point. In its current state, it would not survive another global crisis on the scale of 2008-9.
The Big Mo talks about systemic, technological, behavioural factors related to the current crisis. Bubbles always pass — what is it about now that makes momentum relevant compared with the South Sea/Tulip/Wall St crashes of the past?
Previous crashes were relatively simple affairs driven primarily by people’s collective behaviour, known as the ‘herd effect’. Nowadays, however, crashes are increasingly driven by the ‘system’ itself. That is, the global financial system has become so interdependent and automated, that it develops its own self-perpetuating dynamic – or momentum. This dynamic can be so powerful that, as the Economist Magazine warned in January this year: “Momentum can carry whole economies off track.”
You say that the crisis was down to a momentum building both in a physical and quantum manner. Could the crisis actually just be down to a series of unconnected events that led to this event?
It is true that the crisis was down to series of unconnected events, at least initially. But this is where momentum comes into the picture. The nature of momentum — especially Big Mo — is that it pulls together a range of forces into a particular direction and magnifies their impact. So with the global financial crisis it quickly tied together the subprime crisis, CDOs, system flaws, rating agencies, credit bubbles and lax regulatory environment to create a crisis that was much more than the sum of its parts. Momentum is a force integrator and magnifier that operates at the systemic, behavioural and, some would say, ‘quantum’ level. This is what makes it such a potent force.
You quoted George Cooper about the switch from Laissez Faire to Keynesian policy and say that the switch generates more momentum. Would it have been possible to continue Laissez Faire economic policy?
For instance, in the UK, it has been argued that Northern Rock should have been allowed to fail as long as depositors’ cash was protected.
Yes, I believe Northern Rock should have been allowed to fail provided depositors’ funds were protected. Many other banks should have been allowed to fail too. History teaches us that if an institution or system does not pay the price of failure, then it will repeat the same mistake in the future, often on a bigger scale. Unfortunately, much of the financial industry today is operating as if the global financial crisis never happened. It is particularly disturbing that banks are still allowed to combine their high risk investment banking arms with their commercial and savings arms. This not only makes it very difficult to quarantine people’s savings from high risk activities, it also creates a big systemic risk. The Glass Steagall legislation which separated investment banks and commercial banks should never have been repealed, for it helped compartmentalise different parts of the system so there would be less cross contamination. That’s why ships are compartmentalised, so the whole vessel doesn’t go down when one part is flooded.
Can we really examine and adjust risk with momentum? Can there be working parameters to gauge the risks involved?
Yes, it would be difficult but feasible, and ultimately necessary. A starting point would be to determine the level of ‘interdependencies, scale, speed and friction’ in a system. Plus we should consider how rewards drive behaviour, the types of financial models used, and any external constraints. By mapping these variables it would be possible to gain a clear picture of how susceptible a particular organisation, or system, is to a destructive build-up of momentum. It requires a holistic way of looking at momentum-based risk. We would also have to overcome an institutional bias which tends to see momentum as invariably a ‘positive’ factor rather than as a potentially destructive one.
Can regulators really put ‘grit in the wheel’ through the current reforms and should they?
Absolutely. Nearly every man-made system, whether it be legal, political, ethical, religious or cultural, has built-in ‘braking processes’ to ensure orderly outcomes. The exception is financial services, which seems bent on removing every possible friction point, regardless of the consequences. Consider again the issue of computer based trading. What’s the point of trading, say, a BHP-Billiton stock over and over again in the space of a picosecond? Can the company’s investment prospects really have changed during that time? I think not. Surely it would be better if fundamental investment decisions were made at a more considered pace, rather than at the frenzied speed dictated by automated systems. This hyper speculation is not only unproductive, it also destabilises the system and makes it more fragile. It would seem obvious that some sort of transaction tax – or ‘grit in the wheel’ — is needed to curb such excessive speculation. Of course, the financial industry lobbies strongly against the introduction of such taxes, but the regulators must realise that their prime responsibility is to protect the system as a whole, not its key players.
Now the genie that is the derivative is “out of the bottle” can it be put back? Or, even, should it?
Derivatives certainly have their place in the modern financial system. They can mitigate risk and help ensure more certainty. But the derivatives markets have evolved way beyond their original structure to become speculative bonanzas for big banks and financial institutions, which have become addicted to the profits they generate. So yes, it would be difficult to put the ‘genie back in the bottle’. But action must be taken because derivatives markets are now so large (i.e. over $700 trillion in notional value), so unfathomably complex, and generate so much momentum that they present an unacceptable risk to the financial system.
How can derivatives be returned to a strict hedging activity?
There are a number of ways to do this. Firstly, reduce the incentive for speculative trading by ensuring that derivatives are traded through regulated clearing houses, which enable price transparency.
Currently, the derivatives market resembles the 1990s Nasdaq, in that it is tightly controlled by a relatively small number of participants, who make it difficult to know the market prices of derivatives. It’s a bit like buying a house from a real estate agent without knowing what the seller got for it, because the agent’s commission is kept secret. Greater transparency, as proposed by the Dodd-Frank reform initiative in the US, would help drive down commissions and prices, and make speculative trading less profitable. This could be supplemented with a transaction tax on speculative derivatives trading. A more extreme step would be to legislate against such trading, as the European Parliament did in March 2011 in relation to some debt insurance derivatives, for fear that speculation was deepening the euro-zone debt crisis. Hopefully, by removing incentives for speculative activity, the focus of derivatives would return to their original roles as reducers of risk, rather than as exacerbaters of systemic risk.
You have a look at hedge funds and private equity, calling them Gorillas on Speed, but is this an easy target? Is there a direct correlation between them and the events a couple of years back?
It depends what you mean by ‘direct correlation’. Paul Krugman, the Nobel Prize winning economist, said that the run on the shadow banking system (of which hedge funds and private equity were an integral part) was the “core of what happened” to cause the global financial crisis. This is not surprising considering that, some years earlier, the impending collapse of the hedge fund Long Term Capital Management, posed serious threat to the stability of the American markets, and had to be rescued by the Federal Reserve. Many economists also believe that the 1990s Asian financial crisis was caused primarily by hedge fund attacks on local currencies. Although it is unreasonable and inaccurate to blame hedge funds for the recent global financial crisis, they certainly played their part. Hedge funds and private equity firms operate with such massive scale and speed in a relatively frictionless environment (i.e. unregulated) that they are natural catalysts for market momentum. When such momentum spirals out of control, and turns negative, it can be hugely destructive.
You said that you, like colleagues, were caught up in the rush — when did you honestly realise the dangerous game that was being played?
There was no sudden realisation. It was more like a series of signals. The first occurred in late 2007 while having dinner with an economist friend at the Tate Modern Restaurant overlooking the City of London. All around us expensive wines were flowing. We stared across the river and counted 67 construction cranes on the skyline. It was the height of the building boom. Then I looked down at the ‘Wobbly’ Bridge (Millennium Bridge) and for some reason, I just couldn’t get that word ‘wobbly’ out of my head for the rest of the evening. I know it sounds weird in hindsight, but intuition works in strange ways. Over the next few months, it became painfully clear what was about to happen. UBS was particularly hard hit, morale-wise, by the crisis because we thought of ourselves as being quite a conservative bank, the last sort of place you would expect to be caught up in such a calamity. But that’s the thing about momentum, or Big Mo, it can be so seductive that it blinds you to the dangers up ahead. It is easier to surrender to the flow, which can be the greatest risk of all.
Finally, is the Big Mo here to stay?
Definitely. We have reached an historic inflexion point where the major systems we have created – such as the global financial system – have become so interconnected and complex that they are acutely vulnerable to the forces of large scale momentum. This Big Mo can greatly accelerate and magnify a situation. Social media such as Twitter, Facebook and interconnected smart phones, generated such a potent momentum that it toppled governments. For good and bad, the genie of Big Mo is out of the bottle and will continue to exert a profound impact on our world.
The Big Mo is published by Virgin Books in the UK