End of the World Insurance: the Financial Halting Problem

In computer science, the halting problem is very well known. The problem states that it is impossible to build a software program that can analyze other software programs to determine if they will eventually terminate, or halt. This is a useful problem to understand, because many software problems that look possible at first can be reduced to the halting problem and thus demonstrated to be impossible. It’s common to hear someone say “actually, that seems like a halting problem” when discussing compiler optimization, program analysis, and related problems in computer science. This is much like a physicist might say “but that’s perpetual motion.”

In the sphere of financial derivatives, our civilization has recently come to understand that there are a whole class of financial products which look attractive, and perform reasonably well some of the time, but which eventually fail. The most obvious of these are the credit default swaps of the latest crisis. But other examples include portfolio insurance, made famous in the 1987 market crash. The problem with these products is that they are designed to protect the buyer against losses in all circumstances, even when the market is behaving badly. But when the market is behaving badly, it can behave very badly. These products reduce to end of the world insurance. When the world is ending, who is left to pay out the insurance?

I think there is a useful parallel to the halting problem. If your new financial product can be used as end of the world insurance, it probably will be. And since end of the world insurance is fundamentally flawed, it should raise questions about what your product is really accomplishing.

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