Ali’s blog

Mostly quant stuff with occasional digressions

A diminished role for financial engineering?

Posted by alifinmath on March 14, 2008

In today’s Guardian:

As the treasury secretary, Henry Paulson, attacked banks for creating obscure financial instruments that exacerbate market turmoil, analysts reacted gloomily to a 0.6% drop in February retail sales – far worse than the widely forecast 0.2% rise.

In a speech to the National Press Club in Washington, Paulson accused financiers of devoting too much energy to inventing esoteric securities that leverage mortgages and other debt, making it impossible to find where ultimate risks lie.

“Some financial products have become overly complex,” he said. “Excessive complexity is the enemy of transparency and market efficiency. Investor sentiment has swung hard to risk-aversion, and now the markets are punishing not only complex but non-complex products as well.”

As perhaps I’ve mentioned before, the pricing of financial instruments is based on calculation of risks. At best such calculations are a form of hubris and at worst a calculated deception. For various reasons we cannot calculate financial risks. If there’s one lesson quants should take away from the current situation, it’s that abstruse mathematical calculations using stochastic methods, elegant algorithms, and powerful computers are not any more reliable than more primitive methods. If anything, these methods and tools lend a veneer of fake respectability to the numbers that are churned out. It is probable that the lay public — senior executives, government officials, and the man in the street — now thinks likewise. There is going to be more scepticism towards engineered financial products.

Besides the decreased trust in quant work, it’s more than  likely that the world is turning away, at least in some measure, from financial assets. Real assets — gold, silver, oil, agricultural commodities — have become the new hard currency. Paper money and paper instruments will not be seen as stable repositories of value. And indeed, seen in historical context, the explosion of the financial markets only dates back about thirty-five years or so — ever since the dollar and gold parted ways, and (twin) runaway US current account and fiscal deficits created a global ocean of liquidity.

Geopolitically, this current crisis indicates what a paper tiger the US has become. The current crisis is possibly a tectonic convulsion that will lead to a new dispensation: US hegemony is in its twilight years. As this hegemony disappears and the US becomes just one of many great powers (or even worse), global financial markets — which in a sense have been dependent on US financial, economic, and military leadership — will change beyond all recognition, if indeed they survive at all. 

For these various reasons I believe that quant work will suffer an acute reduction. We are already at a stage where there are far fewer positions available than applicants. Without trying to be pessimistic, we can expect this game of musical chairs to become far more competitive. The number of would-be-quants trying to find suitable employment is expected to rise (a number of new MFE programs have either started or are in the pipeline); the number of jobs will probably decline. One possibility is that MFEs will look at areas that have hiterhto been the province of MBAs. Another is that some quants will drift back to the areas they came from — say post-docs, with their slight chance of subsequent permanent academic employment.

We’ve seen this before in other areas (such as IT): a short-term shortage followed rapidly by saturation, outsourcing, and then tremendous glut as everyone gravitates towards it and universities hastily set up programs. Ten years ago one could count on one hand the number of American (or British) universities offering an MFE. Not today.


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