Frank Partnoy, Infectious Greed (Times Books 2003)

Brilliant science fiction writers have created a wide array of nightmare visions of how technology can be a force for evil. The computer Hal 9000 takes over a space ship in 2001: A Space Odyssey; Dr. Frankenstein's brilliant creation, apparently a medical miracle, is actually a monster; a society loses all privacy, in part as a result of insidious technology, in George Orwell's 1984.

While these scenarios are all thought-provoking, science fiction writers have generally ignored one fertile area in which a fast-approaching future may spell potential disaster: finance. Computer technologies have completely transformed the global financial system, and that transformation is continuing apace.

In his new book Infectious Greed, Frank Partnoy, a professor at the University of San Diego School of Law, depicts the transformation as far from benign. Indeed, he states his theme - and sends his warning - early on in the book: "The truth is that the markets have been, and are, spinning out of control."

Partnoy paints a disturbing picture, drawing on actual cases, of how an individual rogue trader can take down an entire firm, and how derivative instruments may be destabilizing the market. Displaying a flair for the cogent explanation of complex material, Partnoy offers an account that is convincing, interesting, and important.

The Story Begins: The Advent of Derivatives at Bankers Trust and Elsewhere

At the time, academics from the top U.S. finance departments had statistical proof that markets were efficient. The metaphor was that there were no $20 bills laying on the street (because if there were, someone would have picked them up). This theory was a nightmare for Wall Street. After all, its role is to find the $20 bills for its clients.

Krieger refused to believe the efficient market theory, and insisted that smart trading could still make a difference - and turn a profit for investors. To prove his point, he used sophisticated computer modeling, as well as new financial instruments - options, futures, and swap - called derivatives.

Derivatives take their value from underlying assets, such as stocks and bonds, but they take the form of meta-rights. For instance, a derivative owner might not have the right to ownership of a stock, she might have the right to buy (or sell) it in the future. Fortunately for the lay reader, Partnoy explains the complex strategies in easy-to-understand language. (You will learn about such exotic derivatives as FELINE PRIDES and PERCS.)

Column continues below ↓ Derivatives had many advantages. First, there was little if any regulation; the regulators hadn't caught up to the evolution of financial instruments. Second, they could be used in an unregulated area, doubling the advantage: Krieger used currency derivatives; the currency markets were mostly unregulated.

Second, with derivatives, one could, in effect, manipulate the market legally; it would not land you in jail. For instance, a trader could corner a market and exert pressure on the price. This was the case with Krieger, who bought the money supply of New Zealand.

Third, derivatives were flexible. There was no central market for currency derivatives. Rather, traders would create their own instruments, tailor-made to their own specifications, and trade them among themselves.

Truly, it was a Darwinian environment.

On the face of it, Bankers Trust looked like a stodgy commercial bank. It had to comply with stiff federal regulations; its deposits were guaranteed by the American taxpayer. But in fact, its profits came from a very unstodgy - and dangerous - investment strategy: placing casino-like bets on derivatives.

As a result of this strategy, Bankers Trust soon learned that derivatives can be high risk, and their effect on the bottom line very difficult to measure. (Did we make a billion dollars, or really lose a billion?)

Partnoy's Thesis: A Systemic Financial System Failure With Recent Symptoms

With the dangers of derivatives exposed by the debacles at Bankers Trust and Barings, financial institutions began to institute new risk control systems. But powerful, unconstrained forces still remained to destabilize the financial markets.

Among those forces were the increased power and complexity of technology; the lax regulatory environment; the difficulty of measuring new financial instruments and structures with old accounting standards; and growing conflicts of interest. (Financial conglomerates had begun dealing in various different lines of business, meaning that their motives, in a given deal or transaction, were often far from pure.)

There was also a "moral hazard" problem. For example, consider the fate of a hedge fund, Long-Term Capital, that leveraged its portfolio of derivatives to 100 or more times its capital. The firm employed some of the most brilliant minds in finance, including Nobel laureates. Yet the computer models failed to account for a perfect storm of financial crises in 1998, and the fund rapidly lost its capital. Just bad business luck? Not when the government is there to save you.

The Federal Reserve knew that if the fund were allowed to fail, it could have a ripple effect across financial firms across the world. So Federal Reserve Chairman Alan Greenspan orchestrated a bailout, which involved several major financial institutions. That was great for Long-Term Capital, but terrible when it came to creating incentives for fund managers. After all, isn't it rational to engage in high-risk activity if there is protection for the worst-case scenario?

In light of all these systemic issues, Partnoy argues - and I agree - the meltdowns at Enron, WorldCom, and Global Crossing were inevitable. These blow-ups were not isolated events; they were part of a systemic failure in the financial system.

Reform Proposals Have Been Ignored, But Should Not Be

Partnoy devotes the last chapter to his prescriptions to reform the system. In fact, these reforms are quite simple, such as regulating derivatives like other types of financial instruments. Other ideas include: prosecuting complex financial crimes; allowing competition among credit agencies (in a market now dominated by Moody's and S&P); and making it easier for investors to bet against stocks, which would lessen speculative excess.

Unfortunately, it appears that there is little being done to pursue ideas such as Partnoy's. That's a shame, for reform is desperately needed, and the need for it is only likely to increase. And beyond the need for reform, there is also a need to simply match regulations to reality. As many science fiction writers know well, technology will only continue to accelerate. It is up to us to make sure that we manage it, rather than having it manage us.