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Jet airliners transformed into guided missiles. Melting polar ice caps. The collapse of Western financial systems. Such scenarios – once considered so improbable as to be near-impossibilities – have been sufficiently manifest in grim reality over the past decade as to force a wholesale rethinking of what we mean by the term “probable.”

But for all our mental adjustments and cogent explanations of the underlying causes, we have done little to raise our level of acuity in terms of identifying, quantifying or warning of such extreme events in advance. The prevailing view in the aftermath of 9/11, as expressed by Munich Re’s Christian Kluge, was that “There is no mathematical model for terrorism.” Strong vestiges of that sentiment, it would seem, endure to this day.

But what if we could adopt a form of systems thinking that borrows equally from the worlds of finance and intelligence, one that models causality and plausibility instead of statistical correlations and probabilities? One that, in effect, looks a lot more like the real world of today and therefore does a better job of predicting risks in the world of tomorrow?

Veteran Wall Street trader and risk manager Christina Ray has done just that in her new book, Extreme Risk Management (McGraw Hill, June 2010). Several key aspects of the book were examined last week and here we’ll look at a few more.

Arguably the most important part of Extreme Risk Management is a discussion of implications for U.S. national policy and security. As Ray says, “The United States is essentially a meta-enterprise, and one whose existence – at least in its present form – is constantly at risk from threats both old and new. Systems thinking that integrates all the important drivers – geopolitical, financial, and economic – can aid in reducing its vulnerability to the most extreme outcomes.”

Ray then goes on to discuss one specific type of threat: the possibility of financial warfare. While the material predates the so-called “flash crash” of May 2010, it does include a description of methods that might be used to trigger a cascade of orders that disrupt the functioning of global markets.

As the author notes, “Systemic risk and national security most obviously intersect in the realm of unrestricted warfare,” a term borrowed from the English title of a Chinese-language book written by Colonels Qiao Liang and Wang Xiangsui of China’s People’s Liberation Army. Unrestricted Warfare (literally, ‘warfare beyond bounds’) contains a comprehensive description of such warfare in which the authors focus on unconventional means for defeating a militarily or technologically superior opponent such as the United States without the need for direct military action.

Ray goes on to observe that, “The book, which received wide attention when it was published in 1999, discusses a number of unconventional means by which to engage in warfare, including use of international law to the disadvantage of an enemy. However, the type of unconventional warfare the authors favored and that received the most attention was financial warfare.”

As Qiao and Wang put it, “So, which [of many unconventional means], which seem totally unrelated to war, will ultimately become the favored minions of this new type of war – the ‘non-military war operation’ – which is being waged with greater and greater frequency throughout the world? . . . Financial War is a form of non-military warfare which is just as terribly destructive as a bloody war, but in which no blood is actually shed. Financial warfare has now officially come to war’s center stage.”

The sophistication of the recent Stuxnet worm – reported to have penetrated Iranian nuclear facilities – has led many observers to surmise that it was created by a state actor, and that cyber attacks are likely to take front-and-center position in this new type of warfare.

The author notes that such methods are consistent with the new paradigm of warfare. “Hacking into Web sites and targeting financial institutions are two of the methods proposed by Qiao Liang and Wang Xiangsui, in keeping with, ‘The first rule of unrestricted warfare is that there are no rules, with nothing forbidden.’ This is network-centric warfare in both the literal and figurative sense.”

Finally, the book discusses methods for tapping the ultimate collaborative environment: the global capital markets. Although other efforts – most notably DARPA’s infamous FutureMap project – attempted to elicit information from prediction markets, the author makes the case that the global capital markets can prove to be a better source of intelligence. As she says, “The intelligence community and the financial community have much in common. Each community seeks to obtain key data and perform analyses that give it an edge in decision making. Toward this end, each can benefit from the use of market intelligence (MARKINT). In this context, market intelligence is defined as the systematic collection and analysis of open-source information from the global capital and commodities markets in order to derive actionable intelligence from the activities of market participants.”

She describes a method for access to the ultimate collaborative environment as follows:

“The global capital and commodities markets serve as intelligence aggregators, reacting in real time to new information (either public or confidential), expert analysis, and changing risk preferences, as revealed by trading activity. MARKINT is a way to tap into the collective wisdom of market participants, weighted by the size of their bets (which correlates with the quality of their resources and knowledge). Since market prices change continuously, MARKINT is the equivalent of an automated, real-time poll of global subject matter experts (friendly or unfriendly), weighted by their seniority, skill, and confidence in the quality of their intelligence. And this poll can be taken again milliseconds later.”

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