Sunday, April 1, 2012

Benchmark Solutions: Probably a Black Swan for the Corporate Bond Market

Your blogger was a little taken aback by a wire story that ran last night. I'm not entirely sure the journalist involved took accurate notes and pending further clarifying discussion I am not going to repeat her name here. Still, here is the release for those that might be interested.

While equity markets have long seen technological and quantitative progression, the bond markets have remained essentially the same for one hundred years. That’s why the talk on the street is the new transparency service offered by Benchmark Solutions, one so advanced it threatens to change the very nature of the U.S. corporate bond markets. Benchmark’s product is “light years ahead”, according to one customer, and the firm re-prices every corporate bond every ten seconds. That’s something a bulge bracket firm manages once or twice a day so bond market makers have already incorporated the service into their operations. More and more market participants are looking at the so-called Magenta Line, the time series of Benchmark’s constantly updated estimate of bond and credit default swap prices.

The imminent upheaval has prompted some analysts to ask whether the arrival of the Magenta Line is a Black Swan event. The provisional answer is “very probably, yes”. Black Swan events were characterized by post-probabilist philosopher Nassim Taleb as unanticipated developments that have great impact and are rationalized after the fact. And interestingly, Taleb himself may have failed to predict the surprising, benevolent impact of mathematics on bond markets.

That’s the view of Eric Schmalzbauer whose responsibilities at Benchmark include reference data. Schmalzbauer notes the philosopher’s recent submission to an oversight committee for the newly formed Office of Financial Research, in which Taleb insists that many quantitative methods have worked only on computers but not in the real world. That has been true in the past, the philosopher’s argument runs, and therefore, in the absence of a compelling reason, it should be true in the future as well.

Applied mathematician AJ Lindeman notes, in passing, that computers used by Benchmark are very much in the real world and located somewhere in upstate New York. “Our main cluster is not far from here”, said Dr Lindeman, responding to questions from his weekend retreat, “and the mathematics is sound”. When asked to predict whether Benchmark was a Black Swan he suggested it might fill a void. “Yes, I’d like to think this is a Black Swan example because the Black Swan Theory Wikipedia page currently contains no examples at all. I think there used to be an examples section”, continued Lindeman, “but they only had an Earthquake in Japan. People took out the whole section after realizing that was a little bit silly”.

When pressed for his favorite Black Swan event, colleague Joe Leo was cautious, restricting his attention to those nominated by Taleb himself. “I’m still not sure that Harry Potter or Viagra are good examples, though perhaps Harry Potter taking Viagra would count”. After pausing to think for a few seconds, the developer qualified this remark “… so long as nobody thought of it before it happened”. Leo then swore something under his breath, scratched his chin and walked away muttering.

Tim Grant hints that criticism of financial mathematics may have created a special kind of platonic blind spot for pundits, though it isn’t clear if it is big P Platonic or the small p platonic variety. “There is a lot of silent evidence that mathematics works extremely well, but we don’t see it because is silent”, says the new head of sales. Grant suggests a term of art for inductive errors related to applied mathematical progress, a specific philosophical trap he calls mathematical induction.

CEO Jim Toffey is inclined to agree. “You look at the bond markets in 1957. Then 1958. 1959. All the way to the present there’s been virtually no change. But extrapolate that forward even a year or two and you might look like a Turkey. Unless you are British. Then you look like Bertrand Russell’s chicken.”

Dr Stan Raatz, a board member for Benchmark Solutions, suggests that inventions are not always widely appreciated before they exist. Raatz, who has contributed to the philosophical foundations of Benchmark, suggests that no one could have predicted the success of the company, much less funded it or worked for it at an early stage. “People have been harsh on financial epistemology”, notes Raatz who is at pains to defend the Black Swan Theory, “and think that when you take the piss out of epistemology you are left with etymology. Well that’s just not literally true.” 

Stafford Lowe, head of human resources management, believes in a well-rounded approach.  “Like my Prime Minister David Cameron, we’ve found applied mathematics meta-advice and ineffable finance to be a sound complement to precise, logical thinking and the terse, tireless grammar of mathematics.” Benchmark employs verbal meta-advisers to route non-linear and linear problems to the correct teams, in keeping with The Black Swan’s thesis about the distinction between Extremistan and Mediocristan. In Extremistan fractals must be used, notes Lowe, but in Mediocristan more traditional, commodity methods are sufficient.

“The cost savings are enormous”, observes CTO Jim Driscoll, who keeps a copy of The Black Swan on his desk at all times. “Work in Extremistan is expensive because even numbers can’t really be employed - they are thinly veiled linear transformations unsuitable for a non-linear world.” He hinted that the company may be offering new, fifteen year apprenticeships in empirical skepticism to meet a growing demand. “Elephants have long memories”, noted Driscoll, somewhat mysteriously.

Whatever the methods employed, the impact of Benchmark Solutions is now apparent, with industry analysts Celent declaring the arrival of a new, pre-trade transparency era for bonds. But is this really a Black Swan? “Time will not tell”, suggests co-founder Peter Cotton, “because the characterization of Black Swan events becomes cloudier over time. The notion is profoundly unscientific.” Cotton added that he thought that might have come out the wrong way and sound pejorative, due to inadequate media training. “All I’m saying is, I’d Iike to focus on the upside and not worry about the probability of the event itself. Apparently you can build an entire theory of decision making around that notion and it involves going to more parties. Definitely count me in.”