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“The Big Short” – brought to you by complexity in financial products

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“The Big Short” – brought to you by complexity in financial products

By: Steve Sadler, CEO

February 03, 2016

Michael Lewis did us all a great service when he wrote “The Big Short” back in 2010. And Adam McKay has taken it one step further in making a film version that is incredibly entertaining and accessible.

Maybe people will see things more clearly now. Maybe the regular folks will demand some change beyond allowing the uber criminals in Congress and on Wall Street to continue their game of ‘lets pretend’ by creating even more complexity with byzantine regulations named after the crooks who planted the seeds of destruction in the first place (Dodd-Frank).

I have a different idea and different approach to propose. Clearly the time for a fundamental change in how the modern world conducts its financial business is now upon us. We have seen an amazing increase in the complexity and opaqueness of financial products in just the last decade or so. Why is that?

Why has it been that in the past, financial instruments were reasonably understandable and now there are virtually incomprehensible? Many of you may immediately suggest that the advent of computing power is the reason and you would be partly correct. Computers have made possible all sorts of analytical engines that would previously have been so laborious as to eat more value than they created. Thus, complexity is now affordable in a way that it previously was not.

I would posit a different reason altogether: Our basic, systemic failure in the financial arena is not the introduction of enormous computing power into the financial equation. Rather, it is the failure to protect the intellectual work product of the financial engineers with appropriate patent and copyright laws. Complexity, obfuscation and opacity have been used to protect the inventors from having their ideas and property expropriated by imitators before the innovators were able to reap the rewards of their genius.

Why is it possible for an MIT trained mathematician in Silicon Valley to patent a series of mathematical formulas and calculations that become an ‘app,’ but an MIT trained mathematician working for a hedge fund in Chicago cannot protect a series of mathematical calculations that accurately predict financial risks?

In effect, this failure of our legal system requires that complexity be maximized in the “secret formula” sort of way — and that is anathema to transparency and liquidity! The black box model made it virtually impossible for the regulatory infrastructure to detect problems and evaluate risks early enough to take action. I am pretty sure that the SEC would be more effective if Wall Street’s geniuses published their product design in patent application. That would be tantamount to giving the SEC a roadmap for regulatory oversight. Today the Street and the SEC are playing “hide the salami.”

I suggest it is time to change the game.

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