May 30, 2011
by Annelise Riles
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The Nightmare of Transparency

In a recent Business Week article, Hernando de Soto is once again peddling his simplistic view of property rights as the path to pure market transparency. He argues, to considerable journalistic and popular acclaim, that the problem with derivatives markets is simply that property rights are not sufficiently well defined and standardized.  Bring in good old fashion property law and related tools such as title registration, he argues, and the markets will magically clean up.

As I discuss at some length in my book, the proposal is preposterous from the point of view of anyone who knows anything about property law. Property rights are never clear in the way that non lawyers imagine them to be.  As I show with regard to actual cases of property claims in the derivatives markets, as is the case with ordinary property rights, there is tremendous room for interpretation, confusion, conflict and gamesmanship within the language of property law.

De Soto should know better.  He claims to have come upon his insist through field research, and I would venture that even a few casual conversations with any legal expert in the derivatives markets would reveal how property sets the stage for conflict of a different kind rather than bringing pure clarity to things.  But since I have laid out the problems with De Soto’s claim that property achieves transparency in the book, let me ask a different question instead: is transparency tout court always a good thing?

One of the painful rituals of daily life in Tokyo at the moment is the daily review of government statistics on radiation levels.  In response to complaints that it was not sufficiently transparent about radiation risks, the government is now drowning us in numbers.  There are readings taken by each city, each prefecture, and by the national government for each city and prefecture.  There are numbers for each kind of radiation–cesium, iodine, and so on.  Of course the numbers produced by the national and local governments rarely match up.  And we are given no explanation of these numbers since that would be the biased view of government officials–it is just purely transparent information. Truck loads and truck loads of it.

So we the citizens are left to ask ourselves every day how we translate these numbers into an answer to questions like, is it safe for my four year old to play outside today? Is it safe for me to drink the milk or the water? What are the odds of my dying of cancer as a result of my exposure to the rain this summer? And so on.

My husband and I both have PhDs in social scientific subjects and are used to working with data. And yet the deeper we try to dig into these numbers–to compare them for example against the safety standards set by international bodies–the more confused things become. First, it is as if just about every international organization, and every local data collecting body in Japan, has its own system of units.  Conversion between these units turns out to be basically impossible as they are apples and oranges, measuring different things. But some of the problem is simply the violence of probabilities. Learning for example that exposure increases cancer risk by a certain percentage tells you nothing about your own situation since it is based on averages, across global populations (is the average nuclear victim an eighty year old Swede or a twenty year old Bangladeshi?).  And in the case of nuclear accidents we have so little data anyway that those probabilities are probably best described as guesses.

But even though we know that these numbers tell us next to nothing, we can’t stop ourselves. The information is there, it is transparent, so we feel almost compelled to enter into it. Its analysis becomes the daily ritual of our worry.  Did iodine levels go up or down compared to yesterday? And what does that mean, anyway relative to how much iodine our child absorbed, or how much he can absorb?  Every day this analysis of the numbers ends with the same sick feeling in the stomach of total confusion, total lack of clarity about an issue of paramount importance to our family. I experience this daily ritual as its own kind of political violence.  It is as if this absurd cacophony of purely ordered data is taunting me, leaving me all the more exhausted and demoralized.

Now I realize this transparency nightmare seems quite far away from the wonders of property law de Soto would prescribe for the derivatives markets. Yet it is not so different in fact.  After all, market transparency, which is what he advocates, is just a matter of the availability of data. If the data is available, the theory goes, some smart people will make sense of it all. And yet data itself is only meaningful within a framework.  Our problem is that we lack a framework for analyzing the numbers because the people who produced the numbers themselves also lack a singular and coherent framework.  In that situation, the consumer of transparency is saddled with the absurd burden of making meaning–making something standard and comparable–out of what by definition is not standard.  This is often the case in the derivatives markets as well.  In the derivatives markets traders often dodge the pure impossibility of the task by just doing what everyone else is doing–using the same model, the same pricing tool as the next guy, even if we all know its limitations. That is called a herd mentality and we have seen its disastrous effects.

April 21, 2011
by Annelise Riles
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Raising questions about close-out netting

stock market chartEarlier this month, Stephen Lubben at Dealbook posted an interesting piece querying whether there may be hidden costs associated with giving banks huge breaks in their capitalization requirements under Basel III for close-out netting, the clause in the ISDA master agreement that provides that under a long list of specified conditions such as bankruptcy, reorganization, nationalization and so on, one of the parties to a swap transaction can demand that the two sides close out all their obligations and net them all out.  As I explain in detail in my book, Collateral Knowledge, the reason the parties want to do this is that under modern bankruptcy law, even if Bank A cannot pay Bank B because it is bankrupt, Bank B is still obligated to pay Bank A.  If the two sides have netted out their obligations though, the amount Bank B owes Bank A in this situation will be much less–it’s obligation minus whatever Bank A owed it but couldn’t pay.

One chapter of my book is devoted to the events surrounding the passing of a Netting Law in Japan that would guarantee that netting was enforceable.  At the time, ISDA, the International Swaps and Derivatives Association, was busy pushing such laws through in every major jurisdiction in which derivatives trading occurred. And as Lubben says, everyone in the industry asserts that netting is a universal good. In fact, in the entire period of my research I never heard a single person–not a regulator, not a market participant, not even an academic specializing in derivatives–suggest that there were any possible costs associated with netting. But as my research progressed I became increasingly curious about some of the possible costs. Indeed, ISDA’s furious drive to get netting laws passed all around the world suggested to me that someone at ISDA had to believe that there were at least some judges out there who, faced with a case about the enforceability of close-out netting agreements, might see enough costs there to decide to hold the agreements unenforceable. And yet when I queried people about these issues–even people without a direct pecuniary stake in the matter such as academics and bureaucrats–the question was just dismissed again and again as completely out of left field.

Lubben focuses on one possible problem with close-out netting, the fact that the parties can invoke the clause under the contract for a laundry list of reasons, not simply for actual bankruptcy. His concern is that “letting everyone rush to the exits in time of financial crisis” increases systemic risk.  I am not sure if this is as big of a problem in practice as it appears to be on paper.  My research documents numerous occasions in which parties could have invoked the terms of the netting clause but chose not to do so for a variety of interesting and complicated reasons relating to their calculation of what was in their long term best interest. One of the things I try to do in the book is to show how distant law in the document may be from law in practice in the financial markets and this is an example.

However I have another kind of concern about netting agreements. What I think Lubben is really getting at in his comment is that they run an end game around national bankruptcy laws. This means not only that the parties get to liquidate their agreements for reasons that would not be valid under the bankruptcy law but also that in cases of real bankruptcy or reorganization the parties get out of the rules governing who gets paid first. Under the bankruptcy laws of every country I know, swap counter parties would be close to the end of the line of creditors to be paid in bankruptcy.  In other words citizens, through their legislatures, have decided that when there is not enough money left in a bank to pay everyone, others–secured creditors, employees, and so on–should be paid first. Moreover if you compare the class of creditors who would be paid first with the average class of swap counter parties you will find that the former are more local–employees, landlords, tax authorities–while the latter are far more likely to be offshore. But yet netting says forget all that, swap counter parties’ claims come first, before we even get to the bankruptcy priority list. No wonder ISDA members were worried some judges might not see things their way.

And yet in Japan where I did my research there was absolutely no public debate about the netting law. No NGO took up the issue; no bankruptcy law professors raised any concerns; the opposition did not even raise any questions about it. Perhaps it is not too late, in the context of Basel III, to simply begin to ask whether the benefits to market stability entailed in netting really do outweigh the very serious social costs. That would require at least beginning to recognize what those costs are however.

November 21, 2010
by Annelise Riles
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When is a silo mentality a problem in financial markets?

Yesterday at the American Anthropological Association’s annual meeting I went to hear Gillian Tett, a journalist for the Financial Times, talk about how her own training in anthropology (like me, she holds a doctorate from Cambridge) had shaped her reporting on the derivatives markets and the financial crisis.  Tett eloquently explained how anthropologists’ attention to the difference between what people say and what they do, and how the ethnographic method–of observing people intensively over the long run rather than simply relying on public statements or even one to one interviews–had helped her to see the importance of credit derivatives before other newspapers began reporting on them and to sniff out problems in the credit derivatives markets ahead of the crash.  Tett argued that anthropologists’ holistic perspective, and their interest in rituals, in social and institutional practices, in latent hierarchies and in all that gets glossed as “irrational” in economics had an invaluable contribution to make to our understanding of modern finance and to policy debates.

Tett’s own diagnosis of the financial crisis focuses on what she calls “silos”–the way different financial institutions, and different teams within each financial institution, prevented anyone from seeing the big picture.  Stuck in their own little tribe’s group thinking, each team could not see the wider effects of their activities, or the way their perspective was only one among many.  Tett says she sees herself engaged in “silo-busting”–breaking down those barrios with a more holistic approach.

Tett is surely right that a silo mentality pervades certain aspects of the financial markets.  This is one of the ways finance is really like the rest of the world–all of us fail to see the limits of our own ways of thinking.  This is certainly true in the social sciences.  Anthropologists for example are for the most part utterly convinced that their own world view is better than others, and that they are misunderstood and under-appreciated by everyone else.  Economists’ self-confidence about their own discipline’s assumptions is legendary.  Paul Krugman has created a stir by asking whether economists’ over-confidence in their models might not have caused them to miss the financial crisis.  Like Krugman, I think Tett’s diagnosis should cause academics too to ask some hard questions about why we did not do more to highlight and critique the problems in the financial markets prior to the crash.  For myself, for example, fieldwork in the derivatives markets had convinced me long before the crash that all was not well in these markets. My husband (also an ethnographer of finance) and I often joked way back around 2002 that our research had convinced us not to put a penny of our own money in these markets.  But our own disciplinary silo made us feel that it was impossible to counter the enthusiasm for financial models out there in the economics departments, the business schools, the law schools, the corridors of regulatory institutions.  There surely was some truth to our sense that no one wanted to hear that markets were not rational in the sense assumed by the firms’ and regulators’ models.  But maybe we should have tried a bit harder; it turns out many other people also had doubts and thought they too were alone. What might have happened if we had all found a way to link our skepticisms?  The silo mentality is not just about a lack of knowledge.  It is also about a lack of confidence in one’s ability to communicate with people outside the silo.  I don’t think this is anthropologists’ problem alone.  When I ask many of my research subjects why they don’t tell regulators the full story, have just shrugged, “they wouldn’t understand.”
With funding from the Tobin Project and the Clarke Program in East Asian Law and Culture, Tom Baker at Penn Law School and I have sponsored a string of workshops aimed at breaking down disciplinary barriers and getting the conversation about markets going between economists, sociologists and anthropologists.[1] It has been exciting to see how much interest there is on all sides. One of the positive outcomes of the crisis is a greater sense of curiosity about perspectives outside our own silos and a greater commitment to building new conversations.
Still, I wonder if it is always and everywhere a good idea to break down specialized ways of thinking and replace them with a holistic approach.  Take lawyers and back office staff inside the big banks.  As I have written about elsewhere, they lack the big picture: there are lots of things about finance they don’t understand and this sets them apart from traders.  But precisely because they don’t think like traders, they can also evaluate the activities of a trading room with some critical distance.  After all, if they were indoctrinated into the same assumptions as traders they probably would not catch the limitations in traders’ logic that can have disastrous risk management consequences.  So having lots of different groups that think differently from one another with a stake and a role in making decisions is also an important component of financial stability.  In practice, dealing with people who think differently can be a huge pain in the neck–traders don’t much like back office staff meddling in their affairs and vice versa.  Collaborating across differences in expertise is laborious, time consuming, and even wasteful of time and resources, and everyone complains about the other guys constantly.  Yet the requirement that different groups with different forms of expertise collaborate in making financial decisions is a kind of sociological fuse box, a way of slowing things down when they start to snowball out of control.  Sometimes waste and redundancy is a good thing.  The benefits of this fuse box would be lost if everyone had the full picture: traders with back office expertise can more easily circumvent regulatory checks; back office staff with too much training in finance begin to buy into the trader’s world view.
So maybe instead of silo busting, what we really need is more mandates that we collaborate, across our differences. This is true in the academy as much as in finance.

[1] The first Workshop on Behavioral and Institutional Research and Financial Services Regulatory Reform took place at Penn Law in the Fall of 2009. The second one took place in Washington, DC in June 2010. The third one will take place at the Cornell University Law School in April 2011.

November 1, 2010
by Annelise Riles
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Building a Culture of Good Decision-making in Markets

Back OfficeDoes good financial regulation only happen in legislatures, regulators’ offices, and at international meetings of central bankers? What about what goes on between lawyers and their clients, between back office clerks and front office traders? Inside computer systems? What about the mountains of documentation, the procedures surrounding confirmations and disputes? What about all the people, and their tools, that make up a market?

One way to think about this is to ask, what are we trying to achieve, when we talk about creating more stable, efficient, fair financial markets? The answer is that we are trying to change the way things are actually done inside the market. Done by real people, in real situations.

At any moment, thousands of people around the world—from managing directors to administrative assistants and everyone in between—are making decisions, making choices, taking actions—file this document, call Leslie or Hiroshi about this deal, interpret this contract clause this way, buy this company, call the PR firm to see if they could put an ad in the newspaper about this political issue, have lunch with this regulator, and on and on. And those millions of actions, those decisions, are all we mean by markets. When we say we want more stable markets, we really mean that we want to shift people’s ordinary actions.

So all this regulation is just an effort to change real people’s actions, every day, sometimes in big ways, but often in small ways. The next time a middle level staffer at a ratings agency has a gut feeling that the rating of a bank does not fully reflect the bank’s exposure, we hope they will take the time to ask a few more questions, and then pass those questions on to superiors who will do the same. The next time a lawyer for a hedge fund is asked to find a technical legal interpretation of cross-borders securities laws that will limit their client’s fiduciary duties to their own investment clients, we hope they will take the time to ask whether such an interpretation really conforms with the spirit of the law, and to push their client on whether such an interpretation is really in the client’s own long term best interest. The next time a dispute between counter-parties to a swap transaction develops, we hope that the people working inside each of those hedge funds, companies, or banks think work out a negotiated solution rather than deploying “the nuclear option” with domino effects throughout the market.

What do these steps look like, to someone in the thick of things? They can require a little bit of courage—a choice to make just a little bit of trouble for a transaction by asking for more information or raising an issue with a superior. They can require a little bit of extra effort—a choice to take a little more time to go check the facts on a problem when you would rather head out early on a Friday afternoon. They can require a little bit of vision and creativity—to find a win-win solution to a conflict or to see one’s own personal interests, and the institution’s interests, in a longer term perspective. They can require some tools, like workable informal dispute resolution protocols developed by industry associations.

Now in fact, good decisions like these happen all the time. They even happened right in the midst of the last financial crisis. Things could have been far worse than they were in 2008 had not many thousands of people taken reasonable steps to bring whatever stability they could to their little corner of the market. And it could happen a lot more.

What bothers me about much of the talk about financial regulation is that it proceeds as if markets participants were rats in a scientific experiment, motivated only by simple desire for immediate gratification or fear of pain: We will either beat you over the head with penalties if you don’t comply with our securities laws or offer you cash incentives if you do comply (think, the new obscenely large incentives for whistleblowers to now make money on informing the government about the shady practices they made money engaging in before). In fact my ten years of research in the derivatives markets has convinced me beyond a shadow of a doubt that this view of market participants as selfish, brutish and stupid is not an accurate picture. There are many kinds of people working in many capacities in the market, with many different, complicated motivations. But all the people I know, money is only one such motivation. Others include respect from peers, a sense of intellectual challenge and fun, and yes, the satisfaction that one has built something good and done the right thing. If I were to ask many of my informants in the markets why they did the right thing in this or that case, I doubt the first thing that would come to mind would be “because a regulator said I should.”

So what does this all mean? It means that government regulation is one important route to changing markets by changing the actions people take in markets, but it is not the only route. We need much more conversation about what happens, in those key situations, when a person at a critical (but ordinary) juncture in the market chooses Path A or Path B. What are the pressures? What are the options? What influences those choices? What resources do employees need to make the best choices—more time? more knowledge? More support from peer groups? And yes (but not only), financial incentives and fear of penalties? We need to start building a culture of good decision-making.

October 26, 2010
by Annelise Riles
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How is Health Care like Financial Derivatives?

Health Care and MoneyMost people think about the debate about health care reform and the debate about financial regulation reform as quite separate problems. But are they really? Every first-year derivatives textbook tells the student that derivatives are a form of insurance—a way of hedging against risks that are substantial and yet hard to quantify. From a societal point of view, the risk of illness, and the costs of care in old age are one of the largest such risks to the society and economy as a whole, and so health insurance serves a similar economic function as derivatives in providing a mechanism for society to spread large economic risks. For the average working family, both are part of the package of financial decisions that must be made, and trade-offs have to be made between, for example, purchasing a more expensive health plan with higher premiums but better coverage for high ticket health needs versus putting that money in a 401(k). These are different ways of providing for the uncertainties of the future. But they pose similar challenges to ordinary consumers/investors of evaluating complex products provided by retailers who have more knowledge than consumers about what the statistical odds of a payout in the consumer’s favor might be. Obviously costs in one area impact the other: if consumers find themselves facing catastrophic health care expenditures the first thing they will do is withdraw money from their 401(k) to cover those expenses, and they certainly will not have extra money to invest in financial products. So stability and predictability in the area of consumer health care costs also contributes to consumers’ ability to invest in financial products.

One difference of course is that health insurance is a financial product sold to ordinary retail investors. Derivatives in contrast are for the most part available only to what the law refers to as “sophisticated investors”. The good sense behind the insurance exchanges idea in the health care legislation is that the experience from finance clearly teaches us that retail investors are not in a position to sit across the bargaining table from large institutional market players with substantially greater information about the possible risks and rewards of certain financial transactions. Just as securities sold on an exchange are standardized and hence far easier for ordinary consumers to evaluate from the point of view of publicly accessible information, the same should be true of the investments all but the most sophisticated investors make in health insurance.

Some other lessons from the financial debacle may have implications for the health care issue. One lesson of the financial crisis concerned the sometimes unhealthy role played by investment banks, whose staff was motivated by inappropriate incentives, in the valuation of ordinary companies. We see similar problems in the way insurance companies’ mandates are often creating inappropriate pressures on health care providers.

Recently a conversation has begun between specialists in insurance regulation and specialists in financial regulation around these questions. A conference will be held at the Cornell Law School in April 2011 bringing together behavioral economists and institutional sociologists and anthropologists and also regulators and policy makers working in both fields. The conversation between behavioral economists and sociologists and anthropologists of markets has already yielded important insights about 1) the networks through which prices come to be set in the financial markets, 2) innovations in regulatory form and process that can lead to better compliance and more optimal behavior by market participants, 3) what paradigms might replace the neoclassical model and associated rational actor model of human behavior that has undergirded so much market law and policy over the last two decades. At the next conference, we plan to ask how the insights from this conversation might speak to current problems in health care policy design. Our starting premise is that markets are not rational in the sense assumed by neoclassical economics, but that through clever institutional design and the exploitation of cultural practices and social networks we can make significant progress toward market stability.

But the big picture is this: we have been talking about health care as a kind of welfare/wealth redistribution issue and for many, such issues should take a back seat to the problems relating to getting the economy back on track and especially bringing stability and predictability to the financial system. But maybe we should instead think of health insurance as an integral element of the financial stability package?

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