There are three critical fallacies in financial services risk management systems and algo trading systems:
- The future replicates the past. All statistically-based models of future prediction use past events as indicators of the probability distributions of future events – but in a world of change the past is an unreliable guide to the future.
- Risk is quantifiable. Standardised risk management systems can only take account of risk that
can be quantified. Yet, to the extent that risk is dependent on human behaviour
rather than random ‘acts-of-nature’, their inability to take account of the
idiosyncrasies of individual character and behaviour means that standardized
risk assessment algorithms will always be deficient. For example, effective
risk assessment of a personal loan might include the ability to recognize
whether the applicant's personal demeanour suggests drug or alcohol addiction,
or whether their tattoos might hint at membership of a criminal organization. 9/11 was not taken into account in any algo trading system.
- The control system is smarter than the people to whom it is applied. The ability of individual ‘rogue’ traders to damage, even destroy, the institutions that employ them underlines the potential for human creativity to outflank the systems intended to channel and constrain that initiative.
Adopted from Grant & Venzin.
