The day after the new Treasury Secretary Tim Geithner roiled the financial markets with an uninspiring explanation of how the U.S. government plans to end the financial crisis, InformationWeek caught up with Dr. John Bates, a complex event processing (CEP) industry pioneer and founder of market leader Progress Apama, for a lively conversation about how organizations are using CEP as a tool to mitigate risk and keep volatility under control.

John Bates, founder and general manager of Progress Apama

Formerly a tenured academic at Cambridge University in the United Kingdom, Bates is an expert in the areas of capital markets technology, with a specific focus on algorithmic trading, risk and surveillance, and distributed computing systems. "In this market, not surprisingly, our company is having its best year ever," Bates proclaimed. "CEP tools and technologies are increasingly being used by financial professionals to adapt to volatility across a wide range of asset classes." Asked if CEP could help unravel securitized loans and other instruments that have been labeled "toxic assets" by the media, Bates said CEP is best at recognizing skewed values when it comes to the dynamic pricing of things like bonds, options, and equities. "Toxic assets" are complex financial assets held by banks that also have been called "inscrutable assets," which suggests that the financial industry has found a way to create an asset that is so complex that it is almost impossible to untangle the assets and determine their value. "A better term for these might be 'static assets,' since these kinds of structured products such as mortgage-backed securities are typically not priced in real time," Bates said.

Bates explained that CEP engines like Progess Apama are designed to analyze huge volumes of transactions -- 100,000 messages per second with millisecond response time -- and set up alerts and trigger remedial actions by other systems. "With CEP-based surveillance, it's possible to monitor news streams, trader blogs, and news sites to detect particular hard news and rumors and correlate these against buys and sells in the market. In this way, a regulator can keep on top of complex correlated events that may indicate patterns of illegal rumor-mongering followed by activities like stock shorting." Bates said there was a broad spectrum of financial organizations using Apama tools, from governing bodies like the U.K.'s Financial Services Authority (its version of the SEC) that use CEP to do market surveillance to individual financial institutions who use CEP tools to mitigate risk without sacrificing their competitive edge.

A CEP 'heat map' that visualizes patterns of insider trading in real time

"The power of CEP," Bates said, "is in its capacity to do market monitoring and to do it with a light touch -- in other words, to do it in a way that doesn't have to be obtrusive to the normal course of business."

According to Bates, Progress Apama and the CEP industry is at an early stage in using sophisticated algorithms to map business processes to help increase the visibility into risks of financial instruments that are dispersed across institutions or globally.

Bates also said he did not think that this meant financial institutions in the foreseeable future would be subjected to something analogous to retail credit practices, where payment information is compiled and updated constantly by credit reporting agencies and where missing a payment on a mortgage, car, or a credit card can impact overall credit history and force re-pricing of asset loans. "It's a nontrivial problem, to get that kind of roll-up view across an organization," Bates said, especially since many organizations in the current economic crisis aren't aware of who owns what pieces of what risk.

Bates concluded that problems with this kind of risk-sharing are more qualitative than quantitative and can be traced in due course to master investor Warren Buffet's general principle of derivatives, which says that excessive borrowing by traders, investors, and corporations will eventually lead to significant dislocation in financial markets.

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