Vol 6 (2009) - Issue 5

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The Milgram Universe of Credit Derivatives: A Regulatory Proposal – Part Two

Much work in social psychology suggests that in compressed and interactively complex systems, subjects surrender responsibility for their actions in full faith of the system. The leading experiment on obedience, the Milgram experiment, was originally devised by Stanley Milgram to test the willingness of subjects to comply with acts against their conscience under the instruction of authority.

This article is Part Two of a two-part series intended to introduce a version of Milgram’s theory to synthesise and develop the issues surrounding the credit derivatives market in Europe. In the earlier first part of this series, the structure and characteristics of the credit derivatives markets were outlined, with a suggestion on how Milgram’s theory can be suitably formulated to understand and analyse these markets. A preliminary start to Milgram’s theory was embarked on, whereby Milgram’s theory was introduced, to demonstrate why tight coupling and complexity of credit derivative markets necessitate a clearer and more systematic approach as to market regulation. In this process, it was suggested that there are strong behavioural parallels between Milgram’s experimental subjects and institutional actors in the credit derivatives market, due to the interactively complex nature of financial markets.

This second part of the series continues to extend Milgram’s analysis to understand the complexity and characteristics of credit derivatives markets. A regulatory proposal under the aegis of Milgram’s theory will be suggested, focusing on securities markets, but not limited to the sphere of credit derivatives regulation. It will be suggested that an effective regulatory structure should be geared towards decoupling the system, by simplifying products and regulation; and empowering participants with greater understanding and information to increase the effectiveness of checks and balances.

3.3. Beginning the analysis – the ‘tight coupling dilemma’

In a tightly coupled system, the active components are interdependent, and are intimately connected with little space for error or recalibration. The credit derivatives marketplace is built on the tentative balancing of risks, accentuated by highly leveraged positions, and leverage can link markets unexpectedly to distant events.

Tight coupling is evident in three aspects of credit derivatives markets: the structural composition of credit derivatives markets; institutional actors; and lingering systemic threats.

3.3.1. Structural composition

Credit derivatives have complex structures. As earlier emphasised in section 2.2 in this article, alike Russian dolls, credit derivatives often utilise leverage to enhance returns, with structural innovation as a key hallmark of the credit derivatives markets. Further, complexity arises as the leverage can link the market unexpectedly to distant events. As Bookstaber notes, a swaps market can ‘spiral out of control simply because there is some group of overextended investors who happen to have positions that for one reason or another they are forced to liquidate. These interrelationships cannot be anticipated in advance and will shift with the fortunes and market interests of the investors and speculators.’