Today's Post Taken Aurally

The law's very own Black Swan, 1928

Rather than communing with my laptop, tonight I had the pleasure of discussing the challenges of emerging technology with the inaugural meeting of the SCL Junior Lawyers Group.

What differentiates this group is the desire to focus on the context for IT law and lawyers, rather than merely the law itself. As a result, the discussion that continued over drinks ranged from New Journalism, to the difference between facilitators and institutions, to the Cheetah Generation and Steampunk mobile, rather than merely the legal challenges posed by WikiLeaks.

The overriding questions seem to be: where will the key trends take the law and lawyers over the next 100 or 10,000 years? And how do we minimise our exposure to the downside - and maximise our exposure to the upside - of the next Black Swan?

Tweet your top tips using #legaltrends.

Internet Regulation Won't Stop Black Swans

I enjoyed Professor Michael Froomkin's recent "Golden Eggs" lecture on internet regulation. He foresees the future regulation of the internet being shaped by the tension between the 'Cypherpunk' vision for a distributed, democratic , libertarian environment - and 'Data's Empire' - where established institutions respond to the perceived threat of the internet by trying to create a centrally controlled environment. He cautions us not to be complacent or 'technologically deterministic'. There are opportunities for us to make real choices to avoid "killing the goose that is giving us golden eggs of innovation, decentralization, and personal empowerment".

This model does not only describe the two broad forces at work in the online regulatory environment. Generally, our individual desire to control our own experience tends to be opposed by institutions' desire to retain control of how they deal with us. Indeed, it might be said that explosive Internet adoption occurred because individuals pragmatically recognised and seized an opportunity for individual empowerment in the face of comparatively rigid institutional control in the offline world.

Yet institutions try to catch up, and the cycle continues. Michael hints at this when he notes "to a surprising extent both sets of trends have manifested themselves simultaneously. The question is whether those two trends can continue, or if instead we are witnessing the start of a collision between them." Of course, we are seeing collisions everywhere, all the time, between individuals and institutions each trying to control their relationships. Just consider all the markets, services and activities impacted by the Web 2.0 phenomenon, and the realisation that brands must become facilitators rather than institutions.

But we should also consider that 'control' is illusory. Human behaviour is not predictable and, while it may appear that people are acting in a controlled way in certain scenarios or under certain regimes, radical change is never far away. The fall of the Berlin wall and the credit crunch are two of many situations or activities which appear to be under fairly strict, central control but are in fact not - or at least not in any sustainable way. This is not a technologically deterministic view. It simply acknowledges the nature of the world. We are constantly exposed to the risk of "Black Swans" - surprise events that have a major impact which we rationalise by hindsight, as if they had been expected. Andy any inquiry into the why's and how's of such events is largely academic, albeit tantalizingly so.

So, while real regulatory choices of the kind Michael mentions may remain to be made, we should not count on those choices as having the intended effect of delivering 'control' for any sustained period of time. Regulation cannot possibly cover every eventuality, and is too slow to create, too blunt and too easily circumvented by anyone sophisticated and determined. Cryptography and the sheer volume of users and data make a mockery out of online access and content controls, centralised 'mining' and monitoring. We do rely increasingly on facilitators to find desired data and/or edit/adapt it in some way to make it more manageable for us or our devices - and these represent natural 'chokepoints' for regulators and commercial institutions, as Michael Froomkin points out. However, these chokepoints are also easily circumvented, either as described or by the rapid rise of the next facilitator or competitor, and related technological innovation.

This is not to say that those who purport to edit more actively what people see should not be subject to democratic controls over their exercise of editorial discretion. There seems to be (a somewhat surprising) acknowledgement of this in Google's decision to fund the Advertising Standards Association's efforts to regulate online marketing activity. The point is that new standards won't protect us from calamity.

The ultimate challenge, as Nicholas Taleb warns, is to minimise or avoid exposure to the potential downsides posed by Black Swans, while maximising one's exposure to the potential upside. To illustrate this in financial terms, it would be a mistake to borrow money to 'short' stocks, but worthwhile to invest a small proportion of your savings in Hollywood films. In the online world, Black Swans would seem to loom most obviously in the content arena - or perhaps fraud. Regulation is heavily focused in this area, but that is merely a signpost. We must take responsibility for our own practical choices. These include whether to share thoughtful or sordid content, to engage in copyright violation or to openly publish key personal financial data or photographs of your family. It's worth considering that the internet hasn't changed our propensity to behave well or badly, but may have amplified the outcomes.

To bring it down to a personal level, I maintain my anti-virus protection and avoid or minimise sharing what I'd regard as 'key' personal or financial data, even though there are comparatively fewer people out there who would use it to my disadvantage, since the impact their activity is so personally disruptive. However, I do acknowledge that the benefit to sharing certain limited personal transaction data - with credit reference agencies, for example, and some retail or social networks - can outweigh the downside of misuse. In these circumstances, you might think that more regulatory and commercial resource should be dedicated to quickly and efficiently restoring a person's control of their own identity once control is lost, rather than drastically limiting the availability of personal data or intervening too much in the exchange of information in social or retail networks.

Similarly, I post my thoughts and share others' because I hope they are better shared than consumed by me alone - and the (small) chance that millions might find such a thought worthwhile represents a very positive potential experience ;-). Conversely, I would not (even if I wanted to) create or share sordid content because it represents exposure to an extremely negative outcome. That said, I acknowledge a middle ground where (within reason) the assessment of what's merely in good or bad taste is hugely subjective and may change. For example, I recall being struck by the fact that 'topless bathing' was deeply frowned upon in Sydney one summer yet utterly commonplace on Bondi Beach the next. Similarly, we'll hear the last 'cautionary tales' of people losing their jobs over embarrassing photos of university hi-jinks once the 'Facebook generation' become middle managers.

The point remains, however, that we must take responsibility for our own personal vigilence, even if employers come to tolerate the odd embarrassing photo, or the government succeeds in tightening internet content controls. Those Black Swans will still be out there.

John Thain's 10 Lessons of the Credit Crunch

I would summarise the recent remarks of former Merrill Lynch CEO, John Thain, at Wharton Business School in the 10 points below (my adds in italics). But two general observations. First, John says he doesn't believe there could be another bubble as damaging as this particular one, whereas we can't possible know that. It seems a lot safer to assume there will be a more damaging bubble, so we can at least consider what it might be and have some chance of acting to minimise or avoid the consequences. And, second, John is pessimistic that we'll heed these lessons of the credit crunch. So, logically, he would have to concede we're in for a repeat.

1. Loan/mortgage brokers should be incentivised based on loan performance, not just volume;


2. Loan owners who securitise must retain a significant proportion of the equity;


3. Government sponsored entities should be not-for-profit (i.e. they can run at a profit, but can't distribute profits, with an exception here in favour of the Treasury, surely);


4. The issuers of securities need to explain not just the risk in the security, but also what residual risk remains with the issuer and how it plans to cover those risks (this would demonstrate more clearly the inter-relationship between markets for credit and insurance, the use of shadow banks, and related assumptions);


5. Banks must reserve more capital as a proportion of total assets in a rising market, so they can afford to reserve less in a falling market;


6. Private equity firms should not be free of leverage controls (which suggests they need to make the same risk explanation in 4 above to their investors as issuers of other securities, regardless of whether those investors are 'sophisticated' or market counterparties);


7. Financial regulatory structures need to be more logical, less duplicative, less expensive, with no gaps;


8. Compensation should be variable, reflect how earnings are generated, tied to longer-term performance, aligned with shareholders' interests and ultimate financial results;


9. Credit risk management needs to be improved - but the crisis has demonstrated that once toxic assets are on the balance sheet it's tough to get rid of them, so there has to be some recognition that a government guarantee is ultimately necessary to remove them;


10. Financial institutions must pay for their implicit government guarantee, over and above existing FDIC or other financial compensation schemes.

Fool's Gold, Fool's Paradise

I've literally just finished Gillian Tett's Fool's Gold, an insightful, frank and highly readable account of the credit crunch, explained from the standpoint of the JP Morgan staff who somewhat unwittingly unleashed the Bistro-style CDS derivative into an environment of such stunning irrational exhuberance, greed, negligence, recklessness and downright fraud that it's left even the insiders angered and aghast.

And it ain't over yet. While subprime default estimates continue to be revised upwards, bankers brazenly continue to repackage downgraded debt into yet more CDO's backed by leveraged loans.

Importantly, Gillian Tett's narrative tellingly confirms a string of cultural problems that we're told again and again abound in the capital markets trading "pit": regulators whose remit and resources prevent them seeing the financial world holistically, a commission/bonus-driven sales mentality that often ignores the limits of the hallowed Gaussian 'models', banking groups that merely comprise dysfunctional silos, the cosy social contract banks enjoy with government. It's little wonder that everyone lost sight of the big picture - and that our faith in these institutions is utterly shattered.

Yet none of these factors is about to change. Amidst all the talk and shuffling of deckchairs little is actually being done to avoid or minimise exposure to Black Swan events. Hedge funds scramble to avoid the sunlight, like the swaps world did previously, and the quest for transparency has degenerated into protectionist farce. With an election still a long way off, competing government and opposition plans for the financial sector realistically mean regulatory paralysis throughout the time when structural and cultural reform would have been most achievable.

We're living in a fool's paradise. Enjoy.

Fat Cat, Long Tail, Trial and Error

I'm struggling slightly with John Kay's latest article "Counting errors: from the fat cats to long tails."

I understand the point about power laws, and to be careful making assumptions that one is dealing with "normal" data in any given scenario. But a problem I have with this article is John's claim that the long tail of book sales, is "truncated" because books that would only sell 1,000 copies don't get published.

"If book sales are governed by a power law, then if 10 American books sell 1m copies in a year, and 400 sell more than 100,000, then about 16,000 titles will sell more than 10,000 copies.... The rule would predict there would be 640,000 books selling more than 1,000 copies. There are not, and for an obvious reason. Most titles that might sell 100,000 books get published but most titles that would only sell 1,000 do not."

But surely lots of books get published that don't (initially) sell 1,000 copies, because publishers don't accurately predict sales. And surely that's the real point here: only 10 books might sell more than 1m copies a year, but you don't know ahead of time which 10 books. So it's still worthwhile listing on digital platforms titles that initially sell very poorly, because they might yet resonate with enough people who share the same taste and 'work their way up the tail'.

Similarly, John claims that:

"Companies that would have only a few thousand pounds of sales do not continue to exist: people who would have incomes below a certain level are supported by social benefits. To choose appropriate models you need to understand both the maths and the business environment. Media industries and financial institutions have both been unsuccessful in marrying these two skills."

This may be true, but the challenge of non-normal data is that you can't accurately predict which company will not continue to exist, or which people who are on low incomes today might strike it rich tomorrow, like J K Rowling (or they could be wealthy benefits cheats). You can't write off anything or anyone until it or they have actually failed.

On this basis, the conclusion ought to be that participants in the media and financial industries should be prepared to experiment - and fail - a lot before reaching any conclusion about what will necessarily be successful. That was one of my takeaways from The Black Swan.

Or am I missing something?

The Bank That's Fair

Speaking of Black Swans and risk in retail financial services, I just happened across What Were the Credit Card Companies Thinking? on the Harvard Business Review blog. HBR emphasises the point that you can choose to keep ripping people off, but it's inevitable that your business practices will be rendered unsustainable by regulation or customer revolt.

Some might say the predictability of that means it's no longer a "black swan", but the card issuers seemed oblivious or in denial. Like the turkey that's expecting another meal after being fed for 1000 days, only to get eaten. Or like an MP preparing to file another expense claim...

My bet is that this process of exposure and elimination will happen faster and faster as the social media continue to grow and the ripples of influence become more pronounced.

Which reminds me, the House of Lords is due to hear the latest appeal in the bank charges litigation later this month... Will the banks battle on to their death, or see the value in conceding customers' entitlement to refunds?

Black Swans and Risk in Retail Financial Services

In a recent speech, the EU Commissioner for Consumer Affairs, Meglena Kuneva, signaled 5 current priorities in relation to retail financial services:

1. Address the way investment products are designed, described and marketed to consumers; and ensure that new proposals in relation to the sale of credit and mortgages "meet the high standards of modern consumer policy".
   


2. Strengthen the strict rules and enforcement on the misselling of retail investment products, in the light of "clear indications that the laws that are meant to protect consumers were insufficient and may have been repeatedly violated."
   


3. Complete by the end of the summer an in-depth study of banking fees and charges to consumers which appear to be unfairly hitting consumers.
   


4. "Start with regulators a new debate on the correct balance of risk and reward on Main Street. It seems that in recent years, risk has been significantly outsourced to unwary consumers. The question is what amount of risk and toxic products are we willing to tolerate in the retail financial market?"


5. Start a serious discussion on the regulatory oversight structure that is needed to generate accountability to consumers and to ensure consumer protection principles are consistently implemented across retail markets.

The nub of all these priorities lies in the highlighted question. I'm equally fascinated by it, even though the answer to it must surely be "nobody knows." It's part of the process of democratising the financial markets. However, as a starting point for the discussion, I'd be more comfortable with the statement that risk has simply landed on unwary consumers (and taxpayers, more importantly), rather than that it was somehow "outsourced" to them, implying intent and activity on the part of someone else. Otherwise we risk focusing on who outsourced the risk, and how, which is necessarily facing the past, not the future. Nailing those who broke the law should not be part of this debate. The fact is, the law failed to protect consumers and taxpayers from risk in the financial markets.

To put it another way, it was a mistake for us ever to have believed that we had successfully outsourced our own personal financial risk to banks, employers and governments.

The credit crunch is a Black Swan event - a surprise event that has a major impact and is [being] rationalised by hindsight, as if it had been expected. Inquiry into the why's and how's is therefore largely academic, albeit tantalizingly so. To take a counterfactual approach, one might ask whether it would have occurred if the CDO had been strangled at birth in 1987. The CDS also played a role, so we might consider the implications of it's death on a whiteboard in 1997. And we might ask the same in relation to Gordon Brown's rhetorical adoption of the so-called Golden Rule - that the government would only borrow to invest rather than to fund current spending, and in doing so it was "prudent" to maintain debt levels below 40% of GDP (implying it was also prudent to borrow up to that limit).

But we will never really know the cause of the credit crunch. And nothing we do will necessarily prevent another one.

Yet it seems likely and perfectly natural that we consumers and taxpayers will continue to rein in our expenditure, and take steps that we believe will maximise the sustainability of our income, for as long as it takes for us to feel we are able to survive another major financial disaster. As markets seem to "recover" in parallel, it will become harder and harder not to become lulled into thinking that our self-discipline is working, and that, at some ominous peak, we are finally safe...

So the real challenge is: how can we ensure that we consumers and taxpayers always understand that each of us personally bears the risk of financial disaster?

You are on your own. Pay less. Diversify more. Be contrarian!

Why "Pragmatist"?

A pragmatist is simply someone who acts in an informed way to control his or her personal environment, using a combination of theory and practice. Or as John Dewey put it, "intelligent practice versus uninformed, stupid practice". As a lawyer working on innovative solutions to consumer problems, I see plenty of examples of both types of practice.

A pragmatist does not slavishly follow rules, or political dogma, or "positive thinking" or the herd. To do so would assume a world that is somehow ordered, whereas almost all significant events in history are Black Swans - surprise events that have a huge impact and which we rationalise by hindsight. Rules and dogma can turn out to be badly wrong. The herd is eventually caught out. So it's dangerous to follow. Instead, we must rely on experience and critcial thought to minimise our exposure to the downside of these surprise events, and maximise our exposure to the upside.

The combination of theory and practice that qualifies as "intelligent practice" involves trial and failure. It involves being sceptical and "contrarian". It encompasses the aggressive "tinkering" of entrepreneurs - facilitators - who have helped us wrest control of our own life experiences from the one-size-fits-all experience offered by the established music labels, book publishers, retailers, package holiday operators, banks and political parties. These facilitators make the difference between us 'raging against the machine' in a lone, fragmented way and acting together as individuals in a highly concentrated fashion. And this giant, boundaryless online community of practising individuals and facilitators characterises the "architecture of participation" that lies at the heart of "Web 2.0".

It's perhaps no surprise that the rise of Web 2.0 has coincided with a decline and low levels of trust in our institutions, and findings that "the level of alienation felt towards politicians, the main political parties and the key institutions of the political system is extremely high and widespread [yet...] very large numbers of citizens are engaged in community and charity work outside of politics. There is also clear evidence that involvement in pressure politics – such as signing petitions, supporting consumer boycotts, joining campaign groups – has been growing significantly for many years".

In other words, it may be that institutions are being marginalised by people pragmatically engaging with each other in their own digital communities, not only for retail purposes but also political, environmental, health, and economic reasons.

Big questions arise.

How do the institutions get it so wrong? How do facilitators succeed where institutions fail? How can we bridge the gap between what institutions say is right for us, and what is actually right for us personally? Could today's successful facilitators become tomorrow's institutions? Are today's institutions doomed? Or can they respond, re-organise and align themselves with how "we" individual citizens and consumers behave?

I explore these questions here, and look forward to discussing any thoughts or comments you have along the way.