Mad Cow and Mad Finance: The Missing Link

Paris, 17th November 2008 - Jean-Marc Vittori, columnist at French daily newspaper Les Echos, recently suggested¹ to adapt traceability tools developed by the food processing industry to the financial sector as a way to prevent or correct "systemic" calamities in the financial market.

Under-assessment of the risks inherent in certain financial products, due both to opaque contract clauses and to the use of deficient mathematical models, combined with uncertainty about the identity of holders of such products have paralysed interbank liquidity markets, thereby threatening the availability of credit and hence putting the economy at risk.

To contain this "systemic risk", Mr Vittori proposes the implementation of a traceability system based on a central database of financial contracts and positions² that would allow regulators to measure risk concentrations at any point in time. Such a tool would enable the rapid eradication of centres of infection in the event of a crisis.

Mr Vittori recognises that the implementation of such a tool presents serious technical and organisational challenges. One question comes immediately to mind: has the financial industry adopted a rigorous method for representing financial contracts in a computer system? Curiously, it has not. The absence of progress in this area, which lies at the intersection of finance and computer science is astounding given the propensity of these two fields to innovate.³

Admittedly, the issue is complex. It would not suffice to record, for each contract, a set of parameters such as the maturity date, payment currencies, or the list of assets, the prices of which dictate the execution of the contract. The challenge is to create a product definition that can be read by a human being and processed by a computer, and that satisfies three goals:

• describe the rights and obligations of the parties both precisely and exhaustively;
• lend itself to manipulations of various sorts, for example, for the purpose of estimating the contract's value and credit risk, or managing its clauses automatically;
• reflect the evolution of the contract through time.

French software firm LexiFi has resolved the issue of representing financial contracts in a computer system: LexiFi has created the only formal language for describing financial contracts. This original formalism results from a long term research and development effort that was initiated almost ten years ago, jointly with Microsoft Research. LexiFi's offering was developed with technology invented at INRIA, the National Institute for Research in Computer Science and Control, France's leading computer science research institution.

LexiFi's work is essential for improving transparency in the financial industry. The dissemination of a proven tool for describing financial products contributes to the development of well-functioning markets and to the security of both financial firms and their clients.

¹ Jean-Marc Vittori, "Ce que la vache folle peut apprendre à la finance en folie", Les Echos, 6 November 2008, p. 18.

² The issue was discussed in the context of hedge fund regulation during hearings on "Hedge Funds and the Financial Market" organised by the Committee on Oversight and Government Reform of the US Congress on 13 November 2008. See David S. Ruder's testimony (PDF), pages 7-8; James Simons' testimony (PDF), page 7; and preliminary hearing transcript (PDF), lines 259-271, 709-721, 731-733, 1287-1297, 1786-1836, 2203-2213, 2742-2779, and 3174-3231.

³ Leading figures in the financial industry are starting to voice concern over that fact. Kenneth Griffin, Founder and CEO of Citadel Investment Group, declared on 13 November 2008 (see note 2 above): "One of the challenges that we need to address is to have a common language to describe derivatives. Every firm uses a different set of terminologies, a different set of representations to describe their derivatives portfolios." See video, 01:17:08.