August 3, 2012

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TSG IntelBrief: How a Black Swan Became a Red Termite

As of early August 2012, well-acknowledged — but insufficiently addressed — global issues are now presenting themselves not as black swans (outliers that are as devastating as they are unpredictable and, thankfully, rare) or even as white swans (events that are more common and predictable to a degree that their damage can be largely mitigated through clear analysis and proactive responses). Rather, these events are something altogether different. They are more predictable, yet somehow remain seemingly unavoidable. They are more common, yet nonetheless remain historically devastating.

Such events transcend being categorized as either a black or white swan phenomena in terms of predictive theories; instead, they would be more accurately characterized as a red termite, one that thrives in poorly protected infrastructure — and poorly crafted policies — and whose insidious yet predictable damage is almost unavoidable once introduced into the ecosystem. Risk models, legislation, and business plans based either on limiting exposure to once-in-a-lifetime catastrophes or avoiding unnecessary damage from predictable minor events will prove far less useful when dealing with red termite events.

Examples of red termite events include the latest algorithmic short-circuit that led to a curtailing of trading on the New York Stock Exchange (NYSE) — which generated hundreds of millions of dollars in losses — and the long predicted yet still surprising temporary collapse of a major country's (India) power grid. The question confronting government and business leaders alike is this: what happens to the world's existing and future systems and operating models when what were formerly once-in-a-lifetime events begin to occur nearly every year?

As discussed in our June 20th IntelBrief (It Depends: Embracing Instability in Egypt and Elsewhere), there is substantial benefit to be realized by governments and businesses that develop policies and more dynamic models that thoughtfully take into account the persistent instability that has been occurring of late. That thesis remains valid, and is augmented by an examination of two very specific red termites (financial and infrastructural) that are currently chewing their way through networks and into the headlines. These events — like all red termites — are recurring with a frequency that belies the term "unexpected."

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Growing Uncertainty in the Global Financial Markets

The first red termite has infested the underpinnings of the modern stock market. On August 1st, a stock trading software error led to an estimated US$400 million loss for the responsible firm (which left it with what might prove to be insufficient operating capital to stay afloat), uncertain damage to a number of companies hit by the error (and whose stock values gyrated wildly), and increasing unknown long-term damage to investor confidence — both small and large — in the efficacy and transparency of one of the world's largest stock markets. In a hallmark of a red termite, the damage was sudden (faster than human reaction) and, for a while, literally uncontrollable; at the same time, it was also fundamentally a repeat of earlier events…it was, in other words, predictable. As recently as May, the widely anticipated and strategically planned initial public offering (IPO) of Facebook was substantially and negatively effected by computer issues with NASDAQ. Just two months before that, in March, the IPO of BATS Global Market was cancelled when the trading software proved inadequate to the task.

And in the biggest such incident to date, in May 2010, what became known as the "flash crash" caused the Dow Jones average to drop more than 1,000 points in less than 20 minutes, wiping out trillions of dollars in market value before ultimately rebounding. The cause of all of these supposedly rare and random events was the increasing use of high-speed trading that uses algorithms so complicated the human trader is more and more simply a bystander as the markets move. In another hallmark of a red termite, after each of the above events, experts publicly decried the fact that the situation was out of control and, further, emphatically asserted that "something should be done" before the next inevitable incident. When potentially catastrophic events happen often enough to have a nickname — "fat finger crash" in this case  — they cease to be either improbable or even truly unpredictable. Further, when the factors that led to the event are not only still present, but have actually increased, they also cease to be inherently avoidable, only, at best, uncertain. When this occurs, a red termite is certain to be scurrying about, easily seen yet still ignored.

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Disintegrating Global Infrastructure

The second red termite is chewing through the global infrastructure, as witnessed by the historic, but not unprecedented, power outage in India that left almost 700 million people without access to the nation's power grid. In yet another hallmark of a red termite, the latest event will usually be only the most disruptive event in slow-motion parade of such events (the outage in India occurred within a fairly short span of time when other nations  — including the United States — suffered a similar calamity). And yet infrastructure is not just electricity. Whether it is the avoidable near-nuclear meltdown in Japan following the unavoidable earthquake and tsunami; the 2007 unexpected collapse of the I35W bridge in Minneapolis, Minnesota, that structural studies pointed to as expected; or the 2005 devastating flooding in New Orleans that could have been mitigated even though it followed hurricane that clearly could not have been, each infrastructural collapse is met with misplaced surprise...or resignation.

These events were symptomatic of red termites in that scenarios for each of the disasters had been previously  — and extensively — researched and reliably predicted, yet nonetheless dismissed or diminished. When, according to the U.S government,  25% of the nation's bridges need critical repair or that they carry far more than their designed load capacity, then sudden catastrophes — such as a bridge collapse —  are no longer so sudden. Similarly, when public and private policies combine to condense traffic patterns while decreasing new capacity or alternatives, then unavoidable accidents really weren't so unavoidable.

The issue that now confronts public and private sector leaders in equal measure is how to better prepare for, and ultimately avoid or eliminate, these red termites. Perhaps the most vital question they can ask themselves is how to develop effective, proactive models that can account for events that might cause inestimable damage and disruption. A definitive answer will require an objective, self-critical examination of events that should be anticipated given the current policies and priorities, yet remain unanticipated, unwelcome, and unacceptable to citizens and shareholders when they inevitably happen (again).

Future investments, in both the public and private arenas, will heavily depend on how leaders answer one additional question: How many times does something have to break before it can be accurately described as broken?

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