Fracture Critical
/A structure without redundancy is called fracture critical, meaning that a single broken component can collapse the entire structure.
Fracture critical extends beyond engineering to describe many firms in the finance industry:
Hedge Funds: Excess leverage on top of bad trades
Banks: Illiquid long-term assets funded by fleeting short-term deposits
Funds: Illiquid assets with daily redemptions
Allocators: Overcommitment to illiquid/opaque strategies
Managers: Reliance on the one-person, “star” investor model
Firms: One person holding together critical IT, treasury, or operational functions
We know the names of firms that suddenly blew up: SVB, LTCM, Sowood, Amaranth, etc. Why do firms choose this model when the lessons are evident?
Because it’s optimal in the short-term. It’s optimal when you believe you know what the future will hold. It’s optimal when you surround yourself with very talented people that have only experienced success. It’s optimal when the press and investors reward you for excessive risk taking in an up market. Operating in a fracture-critical environment is seductive because disaster never seems close.
Fracture critical systems never provide advanced warnings of the exact breaking point. You must protect all fracture critical points, not just a subset.
Redundancy, the antidote to fracture critical, always has a cost. Holding cash has an immediate cost that many investors won’t pay. Mitigating risk reduces returns in the short run. Adding people hits the bottom line. The costs are always immediate and obvious. The benefits are long-term and go unrecognized. The short run usually wins, so change doesn’t occur.
Engineers apply strict design standards to fracture critical systems, while many investors actively disregard such precautions. There’s always a price to pay when operating in fracture critical systems. It’s only a question of when you pay it.