The Bank of England has released its latest financial stability report. Full report here. Summary here. Summary of the summary: things are OK but the financial system as a whole is highly connected - through things like cheap credit risk and high leverage levels - which means that disturbances can spread more rapidly to become systemic problems. The more highly connected the network, the less stable it is.
In Risk's most recent issue, Duncan Martin and Chris Marrinson look at a similar issue: modelling connectedness between companies as a way of explaining correlation in credit risk. They look at it using a model taken from epidemiology; disease spreads fastest in clusters of closely-connected individuals, such as families. One company's default is considered to make other defaults in related companies more likely.
Current portfolio models don't take account of this sort of closeness, which means (the authors reckon) that they could be underestimating capital requirements by anything from 5% to 100%.
What other mathematical techniques from biology could the financial world be using?

The FT today runs with a multi-part examination of the carbon emissions market. Conclusion? Not good.

■ Widespread instances of people and organisations buying worthless credits that do not yield any reductions in carbon emissions.
■ Industrial companies profiting from doing very little – or from gaining carbon credits on the basis of efficiency gains from which they have already benefited substantially.
■ Brokers providing services of questionable or no value.
■ A shortage of verification, making it difficult for buyers to assess the true value of carbon credits.
■ Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts.

The article also casts a suspicious eye at NatSource, accusing it of overcharging for carbon credits at $4 a tonne. (Which seems to miss the basic point of a market...)

But quibbles aside, the FT's main point is simple: the credit market is too open to fraud; a carbon tax would be better.

Thoughts?
(via macroblog)

A couple of interesting links today.

First, from Information Week, a detailed look at the lightspeed latency issue previously addressed here. There's a good deal of interesting material:

A 1-millisecond advantage in trading applications can be worth $100 million a year to a major brokeage firm, by one estimate...

About 100 firms now co-locate their servers with Nasdaq's, says Brian Hyndman, Nasdaq's senior VP of transaction services, at a going rate of about $3,500 per rack per month. Nasdaq has seen 25% annual increases in co-location the last two years...Later this year, Nasdaq will shut down its data center in Trumbull, Conn., and move all operations to one opened last year in New Jersey, with a backup in the mid-Atlantic region, Hyndman says. [OTC: the mid-Atlantic region? If it's not Bermuda or the Azores, there's not much else out there.]

In Risk, as in any quiz, the answers are generally at the back...

This month, Vladimir Piterbarg looks at a new method of obtaining approximations of European-style option prices. Read the paper here, and then consider these questions:

Numerical methods vs. closed-form solutions: how are increasing computer power and speed influencing research in financial mathematics?

How much do financial institutions value sophisticated mathematical models for their business and money-making machines (as opposed to intuition and straight-to-the-point numerical approximations or forecasts)?

There's a thread on the Forum here to discuss the paper...

Via RGE, this report looks at the risks of leveraged buyout operations to banks.
Conclusion: largely tolerable ("the debt exposures of banks to the EU LBO market are not large relative to their capital buffers") although the size of the market is growing - but there is a caveat (there's always a caveat). LBOs are taking longer to syndicate, meaning that banks are taking on underwriting risk for longer - competition is also driving down margins and tempting banks to weaken safeguards. And, of course, if liquidity dries up in the secondary debt market, big trouble ensues. (And the problem is of course that it's very difficult to predict when liquidity is going to dry up...)

A couple of recent papers suggest that credit derivatives have had positive effects on the sovereign and private debt markets.

Benedikt Goderis and Wolf Wagner (Oxford and Cambridge respectively) write that using credit derivatives can cut down on the problem of moral hazard associated to lending money to someone with sovereign immunity - with credit protection, creditors can hold out for a better restructuring offer from the debtor nation, increasing the incentive not to restructure and (indirectly) reducing the cost of borrowing for emerging-market sovereigns.
There is also good news for borrowers in this draft paper from Adam Ashcraft and Joao Santos at the New York Fed. CDS issuance increases supply of debt, and allows firms with traded CDS to take on more leverage than would otherwise be possible.

A Dow Jones report buries the lead slightly. The point is not that credit default swaps could be used in insider trading; any financial product could be used in insider trading. The point is that, thanks to the fragmented nature of the US financial regulatory system, CDS abuse could fall through the cracks.
I spoke to CFTC chairman Reuben Jeffery last month, and asked him for his views on the system of splitting regulation between the CFTC and the SEC (not to mention the Fed, the OCC and others). His response:

Historically, commodity futures and securities were very different, and so have had different regulatory paths. Now, as markets have evolved, there remain certain things we do that SEC doesn’t do, and vice versa – areas where there isn’t much overlap – but the Venn diagram of overlapping areas has grown considerably over the last several years. There is a growing phenomenon of product convergence, as they become more complex, and there question of whether it is a commodity product or a future or something in between. So there is growing suite of product areas where we and the SEC need to be in regular contact on how to consider products, given our responsibilities and the demands of the market.