These gross intra-system claims have grown rapidly over the past decade, fuelled by off balance sheet activity. CDS growth has outpaced Moore’s Law – the more than doubling of microchip capacity every two or so years. In the CDS market, what were 1000piece watches in 2000 would by 2007 have become more than 64,000 piece. Intra-system claims on this scale increase network fragility. When one node collapses, the ripple across the system risks developing into a tsunami – as Lehman’s experience attests. Herbert Simon recognised just this problem. Hierarchical networks are, in his words, decomposable with intra-system interactions constrained. The financial system has recently evolved in the opposite direction, with intra-system interactions growing and decomposability of the system thereby reduced. Policy initiatives may be able to help. For example, infrastructure could be developed to “net off” gross claims within the financial system. Attempts have already been made to do this in the CDS market, by tearing-up redundant claims among participants. This has reduced outstanding CDS claims by as much as 30%. The same netting principle could potentially be applied to a wider range of contracts and counterparties, to improve the decomposability and hence robustness of the system. 39 Third, financial innovation in the form of structured credit also had the consequence of creating a network structure which was non-hierarchical. Financial engineers created products in which elements of a loan portfolio were reassigned to a higher-order subassembly. In this way, an automatic dependence was created among almost every substructure.
In short, diversification strategies by individual firms generated a lack of diversity across the system as a whole. So what emerged during this century was a financial system exhibiting both greater complexity and less diversity. Up until 2007, many participants in financial markets would have viewed that network evolution as the inevitable by-product of technical progress in finance. Until then, complexity plus homogeneity equalled stability. But in just about every non-financial discipline – from ecologists to engineers, from geneticists to geologists – this evolution would have set alarm bells ringing. Based on their experience, complexity plus homogeneity did not spell stability; it spelt fragility. In understanding why, it is useful to explore some of the wider lessons from those disciplines, taking in turn the effects of complexity and diversity on stability. Complexity and stability Tropical rainforests are a complex adaptive system. In the immediate post-war period, these eco-systems were often used as a case-study when demonstrating why complex systems tended to exhibit greater stability. 3 In Elton’s (1958) words, this was because there are “always enough enemies and parasites available to turn on any species that starts being unusually numerous”. Complexity strengthened self-regulatory forces in systems, so improving robustness. This was the prevailing ecological wisdom up until the early 1970s. That conventional wisdom has since been turned on its head. From the 1970s onwards, orthodoxy was altered by a combination of enriched mathematical models and practical experience.