One of the significant research advancements since the Financial Crisis has been the development of network economics to help understand the propagation and amplification of economic shocks. Economics of networks deal with the linkages across economics agents that make up a market. Agents have different interaction functions or linkages which when blended together or aggregated form a network. Call this the connectivity of markets.
Researchers and policymakers are still trying to determine how to best use networks to understand the transmission of crisis and solve problems; however, it is important for investors to just think through the dynamics of networks in financial markets.
In a past world, this industry analysis would be called market structure, but economics have moved well beyond the descriptive focus of structural analysis. When economic agents are more connected, their micro activities will spill over to other markets and players. Connectedness means that micro shocks can have greater systematic risks. A simple analysis of debt connections during the Financial Crisis can be seen using network technology.
There is connectedness inside the firm, but the focus of network economics is how shocks can ignite or propagate across a whole economic system. Networks drive correlations. Correlations across markets are driven to one not just because there may be a common factor that is changing expectations but also because the activities of some market participants will lead to further reaction by others. A negative equity shock may lead to a margin call which requires a sale of unrelated assets. A failure of one firm may require higher collateral or lending terms for other firms. A bank cutting credit for a set of clients can lead to a cut in production in the real economic. A dollar move can impact bank lending and cause a credit shortage available for cross-border arbitrage. A bank reserve constraint for a money center bank can reduce the funds for repo lending and impact Treasury market liquidity.
As policymakers have become more aware and sensitive to networks, there has been an increased focus on central clearing, the interactions of participants in over the counter markets, and measured the importance of large meaningful financial institutions. During the financial crisis, we learned that the failure of one institution cannot be viewed in isolation because its failure will transmit a shock to all economics agents it touched. Absolute size matters, and who you trade with matters. The contagion from any shock will move faster and deeper through financial markets when there is more connectedness.
An investor does not need to know all of math behind networks, but there are some clear take-aways.
Researchers and policymakers are still trying to determine how to best use networks to understand the transmission of crisis and solve problems; however, it is important for investors to just think through the dynamics of networks in financial markets.
In a past world, this industry analysis would be called market structure, but economics have moved well beyond the descriptive focus of structural analysis. When economic agents are more connected, their micro activities will spill over to other markets and players. Connectedness means that micro shocks can have greater systematic risks. A simple analysis of debt connections during the Financial Crisis can be seen using network technology.
There is connectedness inside the firm, but the focus of network economics is how shocks can ignite or propagate across a whole economic system. Networks drive correlations. Correlations across markets are driven to one not just because there may be a common factor that is changing expectations but also because the activities of some market participants will lead to further reaction by others. A negative equity shock may lead to a margin call which requires a sale of unrelated assets. A failure of one firm may require higher collateral or lending terms for other firms. A bank cutting credit for a set of clients can lead to a cut in production in the real economic. A dollar move can impact bank lending and cause a credit shortage available for cross-border arbitrage. A bank reserve constraint for a money center bank can reduce the funds for repo lending and impact Treasury market liquidity.
As policymakers have become more aware and sensitive to networks, there has been an increased focus on central clearing, the interactions of participants in over the counter markets, and measured the importance of large meaningful financial institutions. During the financial crisis, we learned that the failure of one institution cannot be viewed in isolation because its failure will transmit a shock to all economics agents it touched. Absolute size matters, and who you trade with matters. The contagion from any shock will move faster and deeper through financial markets when there is more connectedness.
An investor does not need to know all of math behind networks, but there are some clear take-aways.
- Think beyond the immediate shock and focus on the second order thinking about connections.
- Connections and networks are everywhere but dynamic. The connections of economic agents matter even in a competitive market.
- More complex the market will be more impacted by network effects.
- Follow the money - where it comes from and where it is going.
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