Computers and algorithmic trading have been around for generations now. Derivatives are simply complicated algorithms meant to "guarantee" returns over time.
They along with "swaps" came to the forefront of the financial conversation during the Great Recession. They continue to be a big deal with the recent Archegos fiasco.
Swaps are part of the derivative equation. This was how Hwang was able to take such large positions with so little collateral. He was able to do a "swap" deal with a bank where they were fronting him huge amounts of money to take risky positions because they believed the outcomes would be positive.
Big banks have been making money like this for generations now.
Swaps are basically backroom deals between banks and big money. Big money has historically had access to the best computers and the best predictive analytics.
This coupled with inside track access has meant SURE THING gambles which pay big. When you have insider info you can place big bets. When your predictive analytics are SO GOOD you can literally predict the behavior of waves of investors, then it is a sure thing.
This is why banks are willing to make these secret swap deals. It makes sense to them because historically these very rich people have had access to the best computers.
They have had the best predictive analytics. That means if you front them money in these swap deals their artificial intelligence just about guarantees massive profits. The banks make enormous amounts of money without taking much risk....unless there is a black swan event.
What if there are multiple black swan events? What if we are in the midst of a Black Pterodactyl event? What if the artificial intelligence is having problems making large scale predictions about the behavior in mass of increasingly irrational humans any longer. Maybe the models used to build out these predictive analytics are too heavily based on old paradigms?
Derivatives are really just very complicated algorithms that make predictions about how money will move based upon various factors. We all know the most chaotic factor to calculate is human behavior. Perhaps we outlived the grand visions of the great science fiction writers of the twentieth century. It may be time for hedge funds to hire some science fiction writers to punch up their predictive analytics algorithms.
Science fiction writers practically invented the ideas behind artificial intelligence and predictive analytics. Specifically, Isaac Asimov postulates a new science called psychohistory in the Foundation series. The name psychohistory is a misnomer because it is predictive analytics and chaos theory applied to humanity, but psychohistory is the name Asimov gave it. Derivatives look a lot like what Asimov called psychohistory.
Psychohistory depends on the idea that while one cannot foresee the actions of a particular individual, algorithms applied to large groups of people could predict the general flow of future events. This is essentially what derivative equations and hedge funds are doing.
The character responsible for the science’s creation, Hari Seldon, established two axioms:
1] the population whose behavior was modeled should be sufficiently large
2] the population should remain in ignorance of the results of the
application of psychohistorical analyses because if it is aware, the
group changes its behaviour.
2] the population should remain in ignorance of the results of the
application of psychohistorical analyses because if it is aware, the
group changes its behaviour.
Derivatives are today’s psychohistory equations. The crazy markets have been making it very difficult for the investing-bots. Also, the second axiom of psychohistory is VERY important …population should remain in ignorance…
Old science fiction has been predicting the future for us since just after World War II. They defined the future we now live in. Those ideas have certainly been a boon to the derivative industry. Hedge funds had the money to get the coders and leverage these ideas.
They had secret swap deals so the population remained in the dark about the manipulations. As we are roiled by crisis after crisis, the backroom deals are forced into the light because they failed. There may not be any heroic investigative journalism happening on this front, but the economic damage has made sure the “population is no longer ignorant”.
It is time for the hedge fund companies to start paying "Professional Futurists". They need to start hiring some science fiction writers or I think we keep seeing these big hedge fund surprises. If you are running a hedge fund reading up on science fiction might make some sense. In fact, start frequenting hackernoon where the bleeding edge of our technological world is on full display.
Disclaimer: The opinions in this article belong to the author alone. Nothing in this article constitutes investment advice. Please conduct your own thorough research before making any investment decisions.