In order to fully understand and analyze systemic risk, it is first necessary to understand the system and its components. This means having a consistent representation of the ‘stuff’ of which the system is made up – the business entities, the contracts between them and the securities that are traded.

Classification is intimately bound up in semantics as we shall see. To create a formal representation of securities contracts for example, one must start by classifying them into different types.

In order to represent the system as a whole – the system within which systemic risk arises – there are two things which need to be represented formally: the components of the system; and the ways in which these inter-relate. Representing the components is relatively simple: this is a matter of formally representing financial instruments and the entities that issue them, trade them and hold positions in them. This is a prerequisite to modeling the overall system as a web of connections between and among those instruments and entities.

A common fallacy is to think that representing financial instruments is a matter of data. Because instruments have a lot of data about them, and because these are maintained in databases, it is frequently assumed that representing those instruments is a data issue, and that solutions to the problems of representing and understanding systemic risk must be technical solutions.

This is not the case. Technical solutions are exactly that – solutions to some problem. In order to develop the right technical solutions, one must first formally set out the problem to be solved.