Financial Econometrics and Empirical Market Microstructure

Amplification Mechanisms Dr ive Systemic Risk

A stress event is a systemic breakdown, which is a form of phase transition. We observe phase transitions in all complex systems. Phase transitions are triggered after a critical point is crossed at which point self-amplification causes a transfor­mation into a state with radically different properties (e. g., solid, liquid, and gas).

The continual tension between amplifying and dampening mechanisms pow­ers complex systems. Financial cycles are driven by the inter-linkage of asset prices, leverage, and risk aversion. Furthermore, the social process of imitation is a major amplifier. Imitation is an efficient form of social learning and adaptation, and is prevalent especially during times of uncertainty (Keynes 1930).

Stability increases asset prices and leverage, and lowers risk aversion, which sows the seeds of future instability (Minsky 1992). As bubbles expand and leverage grows, markets become more tightly coupled and vulnerable to collapse. Eventually, a surprise triggers increased risk aversion and a self-amplifying deleveraging spiral (e. g., bank run). Key dampening mechanisms include countercyclical (and symmetric) central bank intervention (Cooper 2008) and contrarian investment strategies.

History is riddled with unpredictable exogenous shocks, or Black Swans (Taleb 2007). Dramatic examples include extinction events from meteorite impacts or flood basalt eruptions, terrorist attacks like September 11, or technological breakdowns such as the 2011 Fukushima meltdown.[14] And yet, according to Didier Sornette, the majority of financial crises have endogenous origins and can be “pre-diagnosed, quantified and predicted to a degree” (Sornette et al. 2009). He calls these Dragon

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Fig. 1 Amplifying foreshocks. Source: Osorio, Sornette et al. (2010)

Kings (Sornette 2009). Systemic collapses can originate from the predicable amplification of small perturbations in a tightly coupled system. Such endogenous crises are our focus in this paper, as these are risks we can and must manage.

Endogenous crises are characterized by escalating Foreshocks that culminate in a phase transition. We see such patterns throughout nature. Figure 1 from Didier Sornette compares earthquakes and brain seizures, which both exhibit the same pattern of amplifying Foreshocks and mean reverting Aftershocks.

The presence of Foreshocks implies that we need not be surprised by endogenous crises, and that there is a window of opportunity to mitigate risk. A phase transition progresses as follows:

1. A period of stability is interrupted by an outlier, which may be small in absolute terms but unusual from a relative perspective.

2. This initial outlier sets off amplification mechanisms which results in a super­exponential rate of change. This initial period of exponential growth is barely perceptible and typically dismissed as noise initially. The window of opportunity for control shuts quickly as the exponential curve gets steep.

image194Risk managers are continually on the lookout for emerging risks, and recognize that the ability to control risk declines exponentially as risk escalates. This fleeting window of opportunity for exerting control is illustrated (Fig. 2) based on an illustration by reputation risk consultant.




In summary, we can analyze systemic crisis as a function of the following:

1. The structural fragility of the environment (i. e., key fault lines, coupling, amplification mechanisms)

2. A precipitating event (tremor) which pushes the system beyond a tipping point, which sets of a self-amplifying cascade that result in a rapid phase transition (e. g., toppling dominoes)

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