Risk Markets And Politics

Sunday, June 25, 2006

The Poker Face of Wall Street

The July issue of Active Trader magazine has an excellent interview with Aaron Brown, head of credit risk architecture at Morgan Stanley and author of The Poker Face of Wall Street. This is a must-read for anyone interesting in "prediction markets" and the supposed moral aspects of gambling. Brown contends that gambling plays an important economic function, a function in many cases more important than official market purposes such as hedging. He has even claimed that, "Serious poker is a positive sum game." Here are some excerpts from the full article:
Because if the markets are all about price discovery and capital allocation, then they're really like used bookstores. But it sure doesn't look like a used bookstore, and traders make more than people who work in used bookstores.


And I started thinking that it couldn't be a coincidence that credit-fueled volatility and clearing came at the same time, at the same place. Also, I noticed that if you jumped in a body of water near every city that had a poker game named after it and every city that had a futures exchange, you'd float down to New Orleans.


The conclusion I came to was that you have to have a lot of gambling, because you have to move a lot of goods randomly around and you need a lot of people who are good at matching up random goods. Because if you tried to manage the economy just in terms of what the downstream people want vs. what the upstream people want, you'd never get anywhere near the optimization and speed that actually occurred.


[John] Law's ideas about credit and volatility, which are only beginning to be appreciated today, combined with the Native American network economic principles, grew into the modem global economy.


You have to make things jump around and shake them up — then you can get to your new optimum. As a result, you add some risk in the derivatives market. It's like taking an economy and shaking it up a little bit so it can settle down to a better optimum.


Without the right game, the right people don't show up.


If you really believe that finance is not gambling, you do stupid things. You design insurance products that people don't want to buy, and you misprice them. You don't understand why stocks are so volatile, and you mismanage portfolios. You miss the point of commodity, currency, and fixed income markets.

The book contains a foreword by Nassim Taleb that describes the "ludic fallacy": thinking of risk or randomness as something that can be defined, as with the throw of dice. In real life one is never quite sure of the rules of the "game", or what game one ought to be playing.

Another book of interest is 1990's Gambling and Speculation (of which JC Kommer was kind enough to mail me a copy). The authors Reuven Brenner and Gabrielle Brenner make a distinction similar to Taleb's but with different terminology:
The reason for using the word 'speculation' (or 'betting on an idea') is that when individuals carry out the act they do not have enough evidence available to prove whether they are right or wrong. This situation is in contrast to the gambling situation. The latter refers to situations that have been and can be repeated many times, and where the probabilities as well as the monetary gains and losses are the same for everybody and well known.
Since poker involves bluffing, it's a more rich and realistic game than something like blackjack with respect to "legitimate" financial markets.


  • Jason,

    I work with a minor futures exchange and read all of your stuff. We're considering moving into some of these a markets. I guess I'll have to read Aaron Browns book - isn't he the guy about who Wilmott said, 'If the problem is solvable, Aaron Can solve it."?

    I too am slightly concerned about why real estate futures haven't been a success. I feel as though there may be a valid reason in the fact that it is a too exact hedge. As you mention in a later entry, who wants to trade with someone who has much more information than you? Perfect hedges allow some people to have far more information than others about a very specific part of the financial world.

    I'll have to look at Aarons book. Note that this reason is similar to one of the reasons I support mild corruption and govt intervention in the markets, namely that its very randomness helps the markets rather than hurts.

    By Blogger Mickslam, at 3:39 PM  

  • A site called India Stock Exchange http://www.lonympics.co.uk/TheINDIASTOCKEXCHANGE.htm

    By Anonymous Anonymous, at 12:07 PM  

  • Thanks for the kind words. What Paul said was slightly different, and not quite as flattering. He said "Aaron Brown can solve any problem for which a solution is known to exist." That's nice, but not as nice as your version.

    By Blogger Aaron Brown, at 9:19 PM  

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