Rogue Trader? Rogue Numbers!

SPSS for psychology studentsMy niece is about to go to University to read Psychology. I was surprised to find out that on her required reading list is a book called “Discovering statistics using SPSS”. It’s a monster tome of over 800 pages filled with maths. There are chapters on multivariate analysis of statistical variance, the chi-square test with standardised residuals and a section on factor extraction with eigenvalues….. No? Me neither!

SPSS stands for Statistical Package for Social Sciences. It first appeared in 1968 and has been much updated since. The SPSS manual has been described as one of sociology’s most influential books. Why? Because it turns sociology into a science. Most of the statistical methods used in the program, such as the least squared method, were invented by physicists in the 1800s. SPSS allows sociologists to plunder the wardrobe of physics. By dressing up in their clothes, it makes their discipline look more like a hard science and less of a touchy feely one: it now has numbers and maths.

One of my metaphors for catataxis is a shrink consulting a physics textbook when you are lying on his couch telling him about your father issues. He is analyzing your emotions, which are seated in the brain. And the brain, at the most fundamental level, is made up of subatomic particles. But you can’t analyse emotions by looking at subatomic particles; to do so is a catataxic error. You need to use therapeutic techniques not quantum physics – the right tool for the right level. Hence my surprise on finding out that psychology students have to study statistics.

Don’t get me wrong. Of course, statistics are useful things. They enable you to see a pattern that you might miss if you were too bogged down in the details. Statistics transmute a problem up one level, from messy reality on level one to pristine, summarising numbers on level two. Statistics let you see the wood for the trees. To run a regression on a set of data is to perform a catataxic transformation; one that can save lives with medical trials and the like. The problem is that having reduced the world to a numerical one, the judgements made on those numbers can be flawed. There is a nice warm feeling of security that you feel after you have ‘crunched the numbers’ and shown that they support your case. But your confidence in that numerical data mining may well be misplaced.

Which leads us to the UBS rogue trader who just lost that bank £2.3bn dollars. I must confess to some degree of schadenfreude. UBS took over Phillips and Drew in the 1980s, the partnership that I started work with in the City. They then proceeded to destroy it. So to see this global bank that boasts of its risk management skills humbled by a rogue trader brings a wry smile to my face.

“When will banks learn to control risks properly?“ many commentators ask. Surely the lesson is that it is not possible to control risks, not with a spreadsheet anyway. Most statistical methods rely on the bell curve; they assume a normal distribution of risk in order to make the maths work. The problem is that risk is not normally distributed, so traders keep dropping huge sums unexpectedly. Apples fall to earth, tides go in and out, riots happen in the summer and traders bankrupt banks. It’s the natural order of things. Nothing that really needs explaining.

I imagine that the senior managers at UBS looking at the trading accounts felt comforted by the numbers showing how profitable they were. But just as with psychology students, converting things up one level to the numerical domain does not necessarily make things safe, or even true. Just looking at numbers gives a false sense of confidence. Better to look one level down at the real world, the human world, messy and unstructured as it is. I bet the guy sitting on the desk next to the rogue trader all day for the last three years knew something funny was going on…

4 Replies to “Rogue Trader? Rogue Numbers!”

  1. This is Jared Diamond’s distinction between ultimate causes and proximate causes. For instance: why do skunks smell so bad?

    i) chemical biologist explanation: because the molecules the skunks produce causes the experience of a particularly noxious smell in human’s noses
    ii) evolutionary biologist : because the bad smell must have generated some sort of survival advantage, so that the smelliest skunks have survived and the ones that smell like timotei shampoo get wiped out.

    Both explanations are “correct” but the evolutionary biologist has much better ultimate explanation for the phenomena. Now the frequency of large rogue trader losses, seems to be increasing. I’d be interested in what you think the “ultimate cause” of this is?

  2. I guess it is not a surprise that traders lose money. After all, they are supposed to be trading: losing a bit, winning a bit and hopefully ending up ahead at the end of the day. So your point is why are they losing LARGE sums ? This is presumably explained by a number of scaling factors: the increasing size of financial institutions balance sheets (until recently), the multiplier effect of increasingly sophisticated derivatives and the growing size of financial markets. I also imagine that trading losses scale with a power law (like earthquakes, solar flares and power outages) so its quite normal for there to be some big unexpected ones from time to time. But these are probably proximate causes. Maybe we should be focussing on the “Rogue” element – in other words how are they able to take these risks undetected by higher management with their panoply of risk management regimes and compliance protocols?

    I think the ultimate cause is that so called “risk management” in banks is all bullshit – a post hoc confection to keep shareholders and regulators happy. The screenwriter William Goldman’s maxim about Hollywood is appropriate here : “Nobody knows anything”. The rules they use are no good because they can’t cope with non-linear ‘black swan’ events. Even if the rules were good, it’s almost impossible to apply them consistently because of the human factor. By the same argument, there is no unbreakable bank vault or unhackable computer system. Risk management is an oxymoron. Risk management is hubris. The ultimate cause of large rogue trader losses is false confidence in faulty systems and the many hierarchical levels between the trader on the floor and the management on the board.

  3. Hello John,

    It’s Guy here from Brian.inc, I enjoyed meeting you the other day at D Group and I very much look forwards to listening to your talk. Since speaking to you I’ve been considering the relevance to your ideas of a philosopher called Thomas Nagel, you may well be familiar with him, but just in case you’re not I thought it worth leaving an article of his on the page:

    http://evans-experientialism.freewebspace.com/nagel.htm

    That article is titled ‘What’s it like to be a bat’. It is to date, and the best of my knowledge, the best defeat of a reductionist account of mind states written. His argument highlights the difference between describing something and being something. It seems to me it might well prove interesting reading when contemplating how to define the exact difference in purpose based accounts. What I mean by that is that, when considering an example such as the psychologist and the statictician and looking at how they give different accounts of the same thing with each account serving a different purpose, Nagel’s explanation may offer a new perspective on why the two subjective experiences of the same phenomenon can never be reconcilled.

    Hope it makes for an interesting read.

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