I have a question about the intersection of technical math as it relates to capital and commodities markets with technical law. It asks, "At what point, if any, would a crime be committed?"
First, I will provide a bit of technical background to the problem. In 1952, Harry Markowitz proposed a way to think about the relationship between risk and return. It revolutionized finance. He won a Nobel for it. The Nobel is part of the problem. It provides a safe-harbor for financial institutions to use them and avoid liability.
In 1963, Benoit Mandelbrot published a paper that said, roughly, "if Markowitz's model is true, then this data cannot be real data, and it is real data." By 1973, Fama and MacBeth completed a population study, and the Markowitz model was falsified. In 1972, Black and Scholes built an options pricing model, the math behind which is the Markowitz model. You can derive it directly from those models. None of these models have passed validation tests.
At the doctoral level, every financial economist can regurgitate this information. All of these models are built on top of the field of "Frequentist" statistics. They are Frequentist models. Nearly all financial models are Frequentist. It is mostly due to the training. It is this grounding in Frequentism that is the source of the mathematical problem in this question. It is not the only problem with those models, however.
If you wonder what "Frequentist" statistics are, they are the statistics someone made you learn in college with null hypotheses, t-tests, z-tests, and ordinary least-squares regression. Virtually all the money in the world is run on them.
In the field of probability, there is a concept called coherence. It is a property of some probability structures but not others.
A simple definition of coherence would be: A market maker's prices are coherent if a client cannot place a bet or a combination of bets such that no matter what the outcome occurs, the market maker will lose money.
In other words, things such as options or futures prices are coherent if a participant in the market cannot find a combination of contracts where the participant wins one hundred percent of the time.
Between 1930 and 1955, economists, statisticians, and probabilists worked on these problems and determined that Frequentist methods led to incoherent prices. Financial econometrics wouldn't exist until the mid-1970s as a real field. There was no mentoring overlap. Also, coherence is considered a minor feature in statistics because nobody makes a market for Mercury's location relative to the Sun for tomorrow at noon UCT. The sciences don't need coherence. Indeed, if economic models are never applied, then they never need to be coherent either.
So, focusing only on coherence, it is possible, if you know what you are doing, to construct financial contracts where the market making institution will take losses no matter what happens when they use prices built on Frequentist models. I don't think anybody else has noticed this before, or if they have, they haven't opened their mouth.
I have illustrated this in an exercise for economists. It is designed so that a college sophomore with one semester of statistics should be able to provide the standard answer as a simplified model. In it, the economists price a simple problem the way they would a complicated model like Black-Scholes using Frequentist methods. The economists then determine the market prices for the gambles. I then recalculate everything using coherent methods. Forty-eight percent of the time, I have no risk of loss. Fifty-two percent of the time, I have a seventy-five percent chance of winning when I am given even odds.
According to Frequentist methods, I should expect to break even over time. According to coherent strategies, I should expect a forty-eight percent rate of return per contract. Over thirty rounds, I have produced results ranging from turning $100 into $69,000 and up to $7,500,00,000. In the sure cases, I bet everything. In the ones with risk, I bet 48% of my money each round. Frequentist probabilities create a form of mathematical color blindness to the real probabilities.
Now for the law question. Let us assume that there is no attempt to manipulate prices. Indeed, this strategy works because someone wins no matter what price is obtained. The money captured is unrelated to the "risk-free" rate. Frequentist methods allow people to earn the risk-free rate when taking no risk, but these gains are from errors and so are independent of the interest rate on riskless investments. Indeed, if borrowing is allowed, it is possible to invest no money at all.
Let us assume that incoherent prices are present in the market. Let us also assume incoherently priced contracts exist and market makers are unaware. So a clever actor could build a strategy to only enter into a set of contracts where loss is impossible from contracts that are individually highly risky. In normal conditions, the market maker or a broker may extend credit so that the participant may need little of their own money.
The reason market makers are at risk is that they often cover residual amounts. Like a bookie where $1,000,000 is riding on horse A and $1,100,000 is riding on horse B, there is often net exposure if the bookie would allow it. Contracts do not perfectly match up in real markets.
So the first version of this question is, "assume a clever actor has found these contracts and enters into trades by accepting the bid or ask prices available at the market prices. Has a crime been committed?"
The second version requires a little bit more involvement. Assume a clever actor has found these contracts but not in the volume they want, so they make offers that are better than what the market maker is seeking to purchase a larger volume of trades. They are placing limit orders but are not planning on subsequent transactions to reverse these positions as the only goal is to let the contracts expire. Has a crime been committed?
The third version implies evil intent. Imagine that the clever actor is a vengeful sociopath and has enough information to target a particular market maker. They only make trades with this one counter-party on the hook so as to transfer its capital accounts into the nefarious actor's pockets. The behavior is the same, but the goal is to attack a particular institution.
The fourth version would be casus belli, but my interest is legal instead. What if a hostile nation realized that it could effectively rob another nation's food or energy distribution system or capital markets through a set of incoherent contracts, would it have committed a crime under US law when there is no direct target?
Finally, are the publicly traded financial institutions unknowingly violating Sarbanes-Oxley in this example?