Leverage control for market stability

I listened today to a number of extremely informative talks at a workshop in Durham (UK) on Tipping Points in Financial Systems (description here part way down the page). I'll make some comments on the various talks in coming days. But it might be worth noting a few observations on some further progress on a model of market volatility -- and its inherent link to leverage -- achieved by Stefan Thurner and colleagues.

I wrote about this work several years ago in an OpEd for the New York Times, and also in this thing for Nature, but today learned about some further developments which seem particularly important. The model developed in this work makes the point that saavy participants in speculative markets (call them "hedge funds," but they could banks or just one individual) can use leverage to deliver higher returns and thereby attract more investors. This is obvious and natural. Many details aside, however, the model showed that the competition between funds to attract investors drives a race to higher leverage, increasing market volatility, and the eventual probability of violent market crashes. Leverage is dangerous and comes with systemic costs.

This can be seen (in an abstract way, sorry) from the figure below from the paper. In a long simulation of the market, this shows that the likelihood of finding market returns (absolute value of the logarithm of prices differences over a short time) exceeding a value R. The red is how the market works when leverage is low -- the probability to see really big market movements, R > 0.1 or so, is extremely small. But as hedge funds evolve to use significant leverage, the market moves into a regime described instead by the blue curve -- the probability of tail events and extreme movements becomes orders of magnitude larger.

The implication is clear: leverage causes volatility.

But Thurner suggested today that intermediate levels of leverage actually reduce market volatility, because it makes it easier for the saavy hedge fund investors to pounce on and wipe out market mispricings. This is an interesting point and one worth pondering. I haven't yet digested the latter parts of the updated paper, which now considers several policy moves and how they influence volatility, but the results have the wonderful ambiguity that one learns to expect in confronting complex systems. For example, capping leverage at intermediate levels (factors of around 10) is in some case worse than capping it at higher levels (around 15). Controls on the capital reserves held by the funds (or banks) also have some ambiguous results -- in some cases, making them hold higher reserves can lead to more volatility in the market, not less. Weird.

I'll try to digest this new work and report on it's implications once I understand them more clearly, but they already demonstrate the point that our intuition isn't so good at seeing the link between interventions in markets and the likely consequences. I'm certainly guilty on occasion of thinking that if the financial industry is against any proposed regulation, then it must be a good one. Often that's not a bad rule of thumb. But if we're really going to make progress in making markets work for everyone, we need to think very carefully -- and back up proposals with hard evidence. This work is developing such evidence.