How the Gaussian Copula Function humbled a Giant Financial System

Formulas are the alchemy the finance industry uses to turn numbers into profits. But what happens when a formula—so trusted by all—becomes a nightmare that crashes the market? This is the story of an elegant formula that may have done just that.

The Formula that Crippled Wall Street

Pawan J. Shamdasani, Staff Writer
Design by: Jeff Fritz

(First published in the Arbitrage Magazine Issue 2)

In 1998, David X. Li invented the Gaussian Copula Function, a complex formula used to measure and model risk with greater ease and accuracy. A Canadian financial economist and mathematician by trade, Li previously worked in companies like CIBC, Barclays and JPMorgan Chase, but with all this experience, he did not see the impact his formula would have on the financial industry.

For over the past few years, it has been heavily used by some of America’s biggest financial institutions, making it possible for them to sell a substantial range of new securities. Additionally, it was widely used by bond investors, Wall Street banks, rating agencies and financial regulators, which allowed them to make a lot of money—that is, as long as the warnings about the formula’s limitations were ignored.

Unfortunately, those limitations couldn’t be ignored forever, especially when the financial markets began to deteriorate rapidly in 2008, swallowing trillions of dollars and causing one of the biggest recessions since the Great Depression. How did one formula help to humble the giant financial sector? The answer remains with the bond market.