Risks of Innovation - Chatham Financial

In the last week alone, we’ve read half a dozen articles on how technological innovation can improve outcomes in diverse fields. Investors can look to Twitter updates and search engine queries to characterize investor sentiment accurately. The military will be able to decide and deploy much more rapidly through the use of robotic forces. Psychiatrists might start using phone data to track depressive symptoms.

Yet each of these innovations will not come without its own inherent risks. Among the perils to be navigated will include:

(1) Over-prediction: The European Central Bank published an intriguing study this month on how online bullishness (expressed in Twitter updates and Google searches) positively correlated with investment sentiment and led established sentiment surveys. But while high Twitter bullishness predicted increases in stock returns, the stock returns then retreated to their fundamental values. Social feedback emerges with stunning speed, but it can often exaggerate the true magnitude and longevity of sentiment, financial or otherwise. In the study, stock returns didn’t permanently hold to social sentiments, but retreated to the fundamentals.

(2) Loss of control: Military thought leaders report that emergent technologies will transform warfare over the next decades. For instance, when the future of battle is comprised of autonomous robotic units, or at least a hybrid of robots and human partners, battle rhythm may eventually render tactical human decision making far too slow to be viable. What will happen when robots autonomously decide when and how to use lethal force, with human beings only as passive observers rather than proactive deciders?

(3) The illusion of expertise: Earlier this year we wrote about the benefits of tracking personal caloric intake, exercise regimes, and budgetary adherence. But what happens when a smartphone app starts to diagnose — with 86% accuracy, by noting increased phone usage, fewer trips from home, and lack of routine — that its user is depressed? Will said user self-prescribe medicines without visiting a psychiatrist, or stop taking prescribed medicines in the face of a false negative from the smartphone test?

Citizens of the 21st century understand that sweeping, irreversible change accompanies any technological enhancement – each enhancement arrives with great fanfare about its benefits, but subtle risks follow in its train. Like their contemporaries in other fields, finance professionals must consider carefully how to benefit from each innovation without misapplying it.

(1) Accurate Projection: Multinational corporations trying to quantify their financial risks across asset classes run risks of under-prediction and over-prediction alike. It’s vital to employ simulation or shock analysis to understand negative impacts to financial results that could ensue, but these pictures are incomplete. To be as robust as possible, risk analysis has to contemplate the often highly correlated nature of financial asset classes (e.g. the Australian dollar and the price of copper), the risk of contagion from one region to another, and extreme event risks. A reliance on simpler shock analysis alone would be like assessing equity valuations solely by Twitter updates.

(2) Control: It can be very beneficial to set up a rules-based, programmatic approach to hedging budgeted cashflows in other currencies. However, it’s important to re-assess periodically to ensure that a long-established hedging program still fits current business realities. A hedging program set up in one subsidiary with PLN costs may no longer be required based on a newly acquired unit’s high level of PLN sales. Setting up programmatic hedging to run indefinitely without review would be like irrevocably handing over decisions on combat engagement to machines.

(3) Expertise: Our clients’ finance organizations find it useful to see at a glance the current valuations of their debt and derivative portfolios, along with current counterparty exposures. But unparalleled tracking and transparency on portfolio composition and current valuations alone does not necessarily provide true clarity on suitable actions. For instance, overall exposure to Bank A may be much higher than exposure to Bank B, but Bank A may still be a more desirable counterparty for the next trade because of better pricing or less stringent collateral requirements. Making hedging decisions based on a valuations dashboard alone would be like self-diagnosing depression based on a smartphone app.

At Chatham, we’ve invested heavily in technologies that price derivative and loan instruments accurately, enable consolidation and tracking of all debt positions across a worldwide company, and apply the abstruse rules of hedge accounting correctly. However, we’ve also invested in expert advisory teams that understand derivatives structuring, execution, valuation, and accounting. In our experience, the best results don’t come from just a black-box software solution, or just a team of bright finance professionals armed with Excel, but in the marriage of expert advisory and robust technology.