Can Topology Prevent Another Financial Crash?
One overlooked mechanism to forstall the next systemic credit crisis—this occurred to me when I studied these topics in graduate school in the years after the last crisis—is to have central banks issue credit-default swaps against the failure of major financial institutions in their jurisdictions.<p>Since central banks can&#x27;t unwillingly default on liabilities denominated in the currencies they control, this eliminates the second-order credit risk that was a major factor in the last crisis, when AIG and other institutions that issued credit insurance themselves became major sources of credit risk, first in the market for those instruments and then (due to the enormity of their losses) in the wider financial system. If a central bank must pay out on a CDS in the event of a crisis, the situation is little different from what happens anyway: central banks swell their balance sheets, effectively by printing money, to provide liquidity to the financial institutions. By acknowledging and formalizing this inevitable outcome through the issuance of credit derivatives (and by requiring major financial institutions to hold them), central banks can (a) make the financial sector pre-pay for its eventual bailing-out, (b) create a credible means by which to refuse further bailouts, and (c) facilitate a more effective and more informative market for credit instruments, which would help to prevent a crisis in the first place.<p>I suspect that this potential tactic has been ignored mostly because it would be politically infeasible to convince a financially unsophisticated public that CDSs—financial &quot;weapons of mass destruction&quot;, in Warren Buffet&#x27;s phrase—could be part of the solution. (But then it might be feasible: central banks are not accountable to the political process in the way that legislators are.)<p>At base, to tie this back into the submitted article, note that what I&#x27;m suggesting is little different from putting central banks into the role of central-clearing counterparties for credit risk, but with the added feature that these risks would be distilled into securities so that they can be priced and traded, with the concomitant benefits: the parties that receive credit insurance must pay for it, and markets for trading it aggregate otherwise diffuse information about the underlying credit risks.<p>Quite separately—at the same time I was musing about this stuff, I wrote a (rushed and rather mediocre) master&#x27;s thesis that tried to expose the macro-level topology of the global financial system. The idea was to use the statistical correlations between major markets and assets classes to induce the structure of a metric space [0], revealing the &quot;stochastic distance&quot; between markets across time [1]. This ended up not being terribly useful, due to the well known fact that correlations between most markets move toward one in a crisis; the metric structure similarly collapsed in a crisis.<p>0. A metric induces a topology on the same underlying set.<p>1. In the course of my literature review, I found out that Rosario Mantegna had the core of the idea a decade before; see, Mantegna (2000), <i>Introduction to Econophysics: Correlation and Complexity in Finance</i>.