Modeling systemic risks in financial markets

Systemic risk to financial markets is often defined as the risk of a major and rapid disruption in one or more of the core functions of the financial system caused by the initial failure of one or more financial firms or a segment of the financial system ([3], p. 3.) This widely accepted definition sets systemic risks in financial markets as a different class of risk agents in the market face, distinct from more conventional kinds of primary and secondary risks due to a position in a certain security or more generally risks that remain in one’s portfolio due to mis-hedges. The financial turmoil of 2008 and its ongoing reverberations throughout the global financial system such as the debt crisis in the Eurozone, the massive deficit in the US economy and astronomical notional value of the entire derivatives markets make systemic risk an extremely timely topic of investigation for bankers, regulators as well as governments at large. At the same time, standard tools of systemic risk management or, more to the point, catastrophic risk management, have not yet been fully successful in explaining or modeling systemic risk. (It is a widely-held hope in the financial industries that the upcoming Basel III requirements will help mitigate systemic risk though it is not clear how these new regulations will actually mitigate such risks while preserving the hundred years old structure of capital and debt markets.) In this article we discuss some of the triggers for the onset of a full-blown catastrophic breakdown of the financial markets; we will focus on newer forms of triggers that have not been adequately covered in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act in the US markets such as the rise of ultra-high frequency trading as well as possibilities of malicious attacks on the integrity of financial systems. We will also discuss the rise of over-the-counter (OTC) markets in securities derivatives which operate outside the standard exchanges-based framework. We will report evidence from these plethora of topics as an argument that instead of systemic risk “going down”, these new problems are keeping the entire system at the edge of another large meltdown. At the end of this paper we will present ongoing work towards developing computational tools that can simulate systemic risks in the financial markets due to various stressors; towards this end, we will propose a rapid prototype of an algorithm based on network theory that we hope to develop. The paper is organized as follows: in section 2 we will present evidence from the current state of operations in the financial markets that point towards a broader picture of systemic risks as more