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  • Fighting the Machines: New Risks in a Transparent Financial System
  • Grant Long (bio)

Transparency became the ultimate buzzword among policymakers and bankers debating the causes of the turmoil that beset international financial markets from August 2007 well into 2009. Many argued that without the tangled, opaque web of liabilities formed by credit default swaps, collateralized debt obligations, special purpose vehicles, and various other financial derivative, securitization, and funding schemes, the financial crisis of 2007 and 2008 would never have occurred. Advocates of this point have a strong case; with a clearer picture of banks’ liabilities, the seizing of credit markets would not have been nearly as pronounced and might have been averted. The regulatory reforms passed by the U.S. Congress in the spring of 2010 put a high priority on increased transparency in financial markets, and much of the international dialogue has also focused on the need for increased transparency to enable greater market efficiency. To promote transparency, reforms have favored normally traded financial instruments over esoteric, customized securities, and promoted the establishment of entirely new central clearing systems for the previously fragmented financial derivatives market.

Yet just as Congress was debating the final details of landmark financial reform legislation, the markets demonstrated the hazards of focusing exclusively on financial transparency. On 6 May 2010, in mere minutes, major financial indices dropped by as much as 10 percent. In the ensuing frenzy, analysts and journalists cited concerns over everything from the health of European banks to tensions between North and South Korea in an attempt to explain the startling decline. Over time, investigations revealed that the brief episode of panic that roiled the market that afternoon originated not in rational human concerns, but rather in mechanical error. Four months after the crash, the exact cause of the breakdown remained elusive. The difficulty in pinpointing the exact source of the crash highlights the dangers of excessive reliance on mechanical trading. This computer driven trading has become the favored engine to generate returns for many large hedge funds, and depends on simplified securities and transparent financial exchanges through which computers can analyze and submit trades in a rapid manner. [End Page 33] Though financial reform has in many ways addressed the problems of the recent financial crisis, by focusing on transparency, encouraging the standardization of financial instruments, and mandating large expansions in exchanges for financial derivatives, policymakers have increased the potential for a computer-sparked financial panic.

In the same manner that experts lauded the financial innovations that drove derivative and securitization markets until 2007, bankers and economists have traditionally cheered the innovations behind the rise of computer trading. A 2009 examination by a group of Federal Reserve Board economists found that despite alarms that many had raised about the potential for mechanical trading to wreak havoc on markets, empirical evidence suggested that certain computer driven trading platforms actually reduced volatility in foreign exchange markets.1 Their analysis found that human traders, not computers, were responsible for large trades that tended to move market prices, and that in times of high market volatility, computer driven trading platforms tended to provide buyers for panicked investors. These findings echo those of other recent studies, which also cited evidence that certain computer driven trading systems tended to reduce volatility and increase efficiency in the marketplace.2

The greater market transparency advocated by policymakers in the wake of the financial crisis has the potential to facilitate these benefits of computer driven, high frequency trading systems. Yet questions remain about the possibility for computer trading to spark large-scale systematic panics in the market. The conventional wisdom—that computer driven trading contributes to the day-to-day stability of financial markets—may be comforting, but it does not fully account for the potential for isolated events to set off a systemic crisis. Empirical research finds that large-scale correlations in computer trading systems are unlikely, but this does not alone render large movements in the market impossible. Events which have a small probability of occurring at any given time have a much higher probability of occurring over longer time horizons, a lesson in probability that many traders and risk managers painfully learned in 2007 and 2008...

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Additional Information

ISSN
1945-4724
Print ISSN
1945-4716
Pages
pp. 33-35
Launched on MUSE
2010-12-05
Open Access
No
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