Intellectual connections such as these are why so many physicists are interested in problems in finance and, in part, why so many have been recruited into the financial sector. It also helps that physicists tend to be good at computer modeling and working with large data sets.
The edition of Nature Physics in March this year was devoted to the latest academic research into the links between physics and finance. Much of this is in the emerging area of “complex networks,” which aims to describe the behavior of systems containing a number of interconnected discrete elements.
Complex networks are known to have a very wide range of applicability: A biological cell can be viewed as a network of chemicals linked through chemical reactions; the World Wide Web is a network of Web pages connected by hyperlinks. Financial institutions collectively form a network and, by understanding the global properties of the network, it is possible to gain insights into its function.
One such insight is that greater diversification of risk might actually increase systemic risk, not decrease it, as one might naively think. The idea dates back to a paper published in Nature in 1972 by former chief scientific adviser to the British government Robert May, entitled: “Will a large complex system be stable?” The paper was set in the context of population stability in ecological networks and, in simple terms, it is the idea that by complicating matters we increase the numbers of ways something can go wrong.
Using networks, it also becomes possible to understand how the use of leverage by competing institutions can push a market network towards financial collapse and to assess which institutions are systemically important. It is not just a case of being “too big to fail” — an institute’s position within the network matters too.
The network idea brings together the analysis of many superficially very different systems. In the words of Andy Haldane, the executive director for financial stability at the Bank of England, speaking in 2009: “Seizures in the electricity grid, degradation of ecosystems, the spread of epidemics and the disintegration of the financial system — each is essentially a different branch of the same network family tree.”
The recent financial crisis has highlighted the need to better understand how the global markets work. Theoretical developments in statistical physics and complex systems may be able to help.
Jeff Forshaw is a professor at the School of Physics and Astronomy, University of Manchester.