or: a computational complexity model for derivatives fraud
Derivatives pricing has always been a notoriously complex, computationally expensive and potentially breathtakingly remunerative undertaking. This is true enough for relatively vanilla, exchange-traded options, but once one goes off-market and starts applying creative financial engineering, it can get much more complicated. Products like CDOs, CDSs, CDO^2s and their ilk have exploded in recent years creating opaque markets of trillions of notional dollars and accounting complexities we’re still only beginning to understand.
A recent paper, Computational Complexity and Information Asymmetry in Financial Products, by Arora, Barak, Brunnermeier and Ge take things a step or two further as they illustrate using information theory that it may be far worse than imagined as totally undetectable fraud can be engineered into these products. They show that fraud with these products can be undetectable in the sense that the pricing process is a formally intractable problem when the informational asymmetry inherent in the development of these products is taken into consideration. In this context, “informational asymmetry” is a polite way of saying “fraud.”
The authors, from the Department of Computer Science and Center for Computational Intractability at Princeton (man, I want one of their business cards!), demonstrate that if the designer of, say, a CDO wants to cherry-pick amongst bundled assets to maximize their own return, they can do so in a way such that it would be impossible for a buyer of the derivative to know they were being stiffed. The problem can be so hard that if you got the NSA’s mythic clusters humming on a pricing model, they might chug away until the sun falls from the sky before they accurately price it… Co-author Rong Ge provides a FAQ to the paper here and I must hat-tip Andrew Appel for his informative post on the paper.
The “perfect crime” is a puzzle that has occupied the (criminal and otherwise) mind of many a bright and motivated soul from time immemorial. While some may indulge towards the vulgar or base through violence or vice and others might ponder the perfect crime of passion, the cerebral Queen of Crime is surely some form of regulatory arbitrage: committing the crime for which the law has yet to be written or creatively engineering a legal loophole for a crime one has perpetrated or is about to perpetrate. The developers of CDOs are to be lauded as it appears they have materially upped the state-of-the-art of the perfect crime.
hmmm… Is there a Nobel for that?