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Gaming the (risk/legal) system

March 5, 2014

A while back I was talking to some math people about how credit default swaps (CDSs), by their very nature, contain risk that is generally speaking undetectable with standard risk models like Value-at-Risk (VaR).

It occurred to me then that I could put it another way: that perhaps credit default swaps might have been deliberately created by someone who knew all about the standard risk models to game the system. VaR was commercialized in the mid 1990’s and CDSs existed around the same time, but didn’t take off for a decade or so until after VaR became super widespread, which makes it hard to prove without knowing the actors.

For that matter it is reasonable to assume something less deliberate occurred: that a bunch of weird instruments were created and those which hid risk the most thrived, kind of an evolutionary approach to the same theory.

I was reminded recently of this conspiracy theory when Joe Burns talked to my Occupy group last Sunday about his recent book, Reviving the Strike. He talked about the history of strikes as a tool of leverage, and how much less frequently we’ve seen large-scale strikes and industry-wide strikes. He made the point that the legality of strikes has historically been uncorrelated to the existence of strikes – that strikers cannot necessarily wait for the legal system to catch up with the needs of the worker. Sometimes strikers need to exert pressure on legislation.

Anyhoo, one question that came up in Q&A was how, in this world of subsidiaries and franchises, can workers strike against the upper management with control over the actual big money? After all, McDonalds workers work for franchisees who are often not well-off. The real money lives in the mother company but is legally isolated from the franchises.

Similarly, with Walmart, there are massive numbers of workers that don’t work directly for Walmart but do work in the massive supply chain network set up and run by Walmart. They would like to hold Walmart responsible for their working conditions. How does that work?

It seems like the same VaR/CDS story as above. Namely, the legal structure of McDonalds and Walmart almost seems deliberately set up to avoid legal responsibility from disgruntled workers. So maybe first you had the legal system, then lawyers set up the legal construction of the supply chain and workers such that striking workers could only strike against powerless figures, especially in the McDonalds case (since Walmart has plenty of workers working for the mother company as well).

Last couple of points. First, only long-term, powerful enterprises can go to the trouble of gaming such large systems. It’s an artifact of the age of the corporation.

And finally, I feel like it’s hard to combat. We could try to improve our risk or legal system but that makes them – probably – even more complicated, which in turn gives massive corporations more ways to game them. Not to be a cynic, but I don’t see a solution besides somehow separately sidestepping our personal risk exposure to these problems.

Categories: finance
  1. March 5, 2014 at 8:29 am

    “perhaps credit default swaps might have been deliberately created by someone who knew all about the standard risk models to game the system.”

    Perhaps VaR might have been deliberately created by someone who knew all about risk to game the system.


  2. Zathras
    March 5, 2014 at 12:03 pm

    With franchised businesses, the gaming is there, but not specifically to screw employees. That’s just a side benefit. Opening a new restaurant is extremely risky. While there is much less risk in a franchised location, it is still a risky proposition. The purpose of franchising is to pass the risk to individual franchise owners (and by extension, their creditors) while saving the benefit to McD’s, etc. There is no conspiracy here: that is the whole purpose of franchising. The risk to the franchise owner does include employee lawsuits, from workers’ comp or other reasons, but also includes liability from safety issues, as well as ordinary financial risk. It’s not quite “heads I win, tails you lose” for the larger corporation but it’s least “heads I win, tails I don’t lose.”


    • March 5, 2014 at 12:04 pm

      So maybe I think about the evolutionary model here as well.


      • nnyhav
        March 5, 2014 at 6:35 pm

        Co-evolutionary, but not with VaR. CDS were attractive to IBs as means of shorting corps, KMV provided a rationale for risk quantification. CDOs (which further drove CDS mkt), maybe you’d have a case, esp rating-agency-[un]wise, but even that’s zerohedgey (esp given IB losses taken on superseniors).


      • Larry Headlund
        March 7, 2014 at 8:42 am

        Franchising has the benefit of allowing expansion without diluting the founders’ power through raising capital. If the new stores were owned outright, the parent would have to raise the money for purchasing buildings and so forth centrally. Instead with franchising. This was probably the primary reason McDonald brothers franchised.

        Note that the centally owned chains (Olive Garden, In-and-Out. etc.) have similar unionizing rates as the franchises. In the service industry it is only large operations like hotels in major cities which have been succesfully organized.

        Note also that franchises may not be individually owned. It is not uncommon for a single individual to own multiple franchises in an area.

        Thus I think Wal-Mart would be a better place to look for gaming the system than food franchises.


  3. March 5, 2014 at 1:20 pm

    I see only one solution for individuals. Nodes. We build a small business node network and only buy from or contract with other members of the network.


  4. David18
    March 5, 2014 at 3:34 pm

    McDonalds makes most of its money by purchasing the land that the restaurants are sited on and leasing the site to franchisees.


    • Larry Headlund
      March 7, 2014 at 8:43 am

      Indeed. They are sometimes described as a real estate company with a specialized customer base.


  5. Charles
    March 5, 2014 at 6:28 pm

    Strike is a way to create an artificial scarcity of workers to improve their condition. The problem with artificial scarcity is that it is a non cooperative game, and is therefore quite unstable. The only way to make it robust is to have a REAL scarcity of workers. For instance, after the Black Plague, even in the dire institutional conditions of the Middle Ages, income for laborers increased significantly : landowners had no choice than to pay more to have their land cultivated. Unfortunately, affluence fed into fertility and less than a century later, the situation for workers was back to square one, which suggests to me that the ultimate union tool is the contraceptive pill (and tariffs with countries which didn’t achieve their demographically transition yet) !
    Similarly, the best way to get rid of CDS and derivatives in general is to remove the possibility by the legal system to enforce money debts, allowing only for “real stuff” rentals


    • Min
      March 7, 2014 at 6:38 pm

      A few years after the Black Death in the mid-14th century, there was a backlash in England by the gentry and nobility against the newfound economic power of the peasantry. Prices and wages were rolled back, travel was restricted, people could be forced to work for someone for a year at their demand, and almsgiving was outlawed, except to the young, the old, and the disabled. Also, lands were converted to raising sheep, which requires fewer hands.

      I wonder if the economic liberality of Italy and the economic power of the peasantry and bourgeoisie laid the groundwork for the Renaissance.


  6. faizulramli@yahoo.co.uk
    March 6, 2014 at 2:24 am

    Here’s a question for you Cathy (sorry to diverge from the topic), what, in your opinion, is a viable risk measurement alternative tool to VaR? I am an internal auditor in an investment management firm and we still rely a lot on VaR and C-Var…
    Empower your Business with BlackBerry® and Mobile Solutions from Etisalat


  7. March 6, 2014 at 6:17 am

    Reading this :
    “credit default swaps (CDSs), by their very nature, contain risk that is generally speaking undetectable with standard risk models like Value-at-Risk (VaR). It occurred to me then that I could put it another way: that perhaps credit default swaps might have been deliberately created by someone who knew all about the standard risk models to game the system.”
    got me to recollect a working paper I skimmed a couple years ago. That paper was: “Computational Complexity and Information Asymmetry in Financial Products” by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, Rong Ge
    An extract from the paper reads as follows :
    “This paper puts forward computational complexity as an aspect that is largely ignored in such discussions. One of our main results suggests that it may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields. (Note that since this is a hardness result, if it holds in simpler models it also extends for any more model that contains the simpler model as a subcase.) This result immediately posts a red flag about asymmetric information, since it implies that derivative contracts could contain information that is in plain view yet cannot be understood with any foreseeable amount of computational effort. This can be viewed as an extreme case of bounded rationality [GSe02] whereby even the most sophisticated investment banks such as Goldman Sachs cannot be fully rational since they do not have unbounded computational power. We show that designers of financial products can rely on computational intractability to disguise their information via suitable “cherry picking.” They can generate extra profits from this hidden information, far beyond what would be possible in a fully rational setting. This suggests a revision of the accepted view about the power of derivatives to ameliorate the effects of information asymmetry.”
    If these results are indeed true (I can barely work through the computational complexity arguments), then we probably are in even murkier waters than good old VaR / CVaR / or any other favorite ‘coherent’ risk measure can portend.


  8. jmakansi
    March 6, 2014 at 9:55 am

    Donald MacKenzie’s “An Engine, Not a Camera,” has what I believe to be the best reasoned explanation of why VAR dominates investment.
    What other organizations are structured similarly to the ones you mention, above layers insulated from the bottom ones? Oh year, the mafia.
    Most models used to explain/rationalize/minimize risk in activities fundamentally driven by human behavior are used as clever forms of marketing at the top echelons of organizations.


  9. mdb
    March 6, 2014 at 9:56 am

    You are making progress in finally figuring out that if you change the rules, people change their behaviour. Once you make the full realization, you will know that most (if not all) grand regulatory schemes will fail (and yes small companies change their behaviour as well). At that point will you still be a progressive or liberal or whatever you identify as? Doubtful


    • March 6, 2014 at 11:15 am

      Don’t hold your breath. I think regulators should be way more hardcore, but I’m not ready to “let the free markets” solve all problems. Not gonna happen.


      • mdb
        March 7, 2014 at 11:04 am

        So regulators are more hard core, do people stop thinking? No, they continue to evolve just like the regulations. The problem with believing regulation will stop a problem is that it assumes a static world. Look at the drug war, pretty hard core regulation, has it worked? I always love to see the new ways the drug smugglers find to get/make drugs in the country – it’s funny to watch. But I am sure your hard core regulation will find a static world where no one adjusts and once the hard core regulations are set in stone the world will be perfect. I eagerly await fantasyland’s birth.


        • Min
          March 7, 2014 at 7:39 pm

          By your line of reasoning, in a predator-prey arms race, the prey should just give up.


    • Zathras
      March 6, 2014 at 11:25 am

      What Cathy said. Reality is not “one narrative fits all.”


  10. crocodilechuck
    March 6, 2014 at 4:47 pm


    Both were developed at JP Morgan in the early ’90’s. btw, the story of the development of CDS by Blythe Masters was well covered by Gillian Tett in ‘Fools Gold’



  11. March 15, 2014 at 10:14 am

    Cathy, could you sketch out the CDS point you made? Something to do with not taking into account counter party risk or stuffing the tails? From what I have seen CDS mostly hedge out risk a la plain interest rate swaps, which is pretty legit.


  12. Nathanael
    March 19, 2014 at 10:53 pm

    Hate to say it, but the Communists knew the solution. So did the French in 1789.

    The feudal system had equally complicated methods of indirection to make sure that the King and upper aristocrats never took responsibility for anything.

    Eventually, the merchants and the peasants got together, got the support of the soliders, and killed the King and upper aristocrats.

    Is there another option? I’d like to find one, but historically I don’t see one. Even in the case of the Civil War, Sherman determined that the only solution was to kill roughly 10% of the Southern white aristocracy in order to cow them. (He didn’t get to kill that many and as a result they weren’t sufficiently cowed, but that’s another matter.)


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