11/22/13 – A Trip into the Matrix

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 22, 2013 8:35:27 AM

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In many respects, cyberspace seems like old hat today. The ironic Onion article about the man who lives in cyberspace, basically buying books on Amazon and checking his friends on Facebook, sums it up nicely. William Gibson’s seminal novel Neuromancer, which introduced the term cyberspace, holds up pretty well, and The Matrix remains entertaining.

My experience yesterday at the Markets Media Global Markets Summit, however, really brought home for me how technology continues to evolve and affect what we do, as investors, on a daily basis. By and large, the panels were concerned with the changes in the trading infrastructure—legal, technological, and institutional—that underlie the financial system.

As investors, almost all of us operate at a higher level of abstraction. We drive the car, but we don’t worry about the transmission’s operation. That’s fair enough, but a bit worrisome when the transmission is actually being replaced while you’re driving home.

This is essentially what’s happening. Financial markets operate at the intersection of regulation, technology, and business, and are changing perhaps faster than any other area of the economy—including consumer technology, for all the coverage of iPads and iPhones.

New exchanges are opening on a monthly basis. Existing exchanges are being bought and sold and merged. (One of the panelists yesterday couldn’t comment in detail because he is currently involved in a major merger.) Regulations have upended the markets several times in the last decade and will continue to do so. Trading and technology have moved to the microsecond level, with new microwave tower networks being built between cities to provide that crucial microsecond edge.

Fascinating stuff, and I freely admit I don’t understand any of it on a deep level. Thinking about it on the train ride home, though, there are some points that resonate with what I do, and what regular investors do.

The first is that we cannot assume we understand how markets work. I follow this rule more closely than most, and have a reasonable (I thought) top-level understanding, but clearly I don’t know as much as I should. Changes are under way that do affect the individual investor, and a rational ignorance of the details is no longer so rational. The details are radically different than they were even a couple of years ago. As always, it’s not what you don’t know, it’s what you don’t know you don’t know that kills you.

The second point is to question the purpose of all this activity. I was, in many ways, the onion in the fruit salad at this conference. As interesting as it was, most of the attendees were deeply embedded in this particular culture, and no one that I saw was asking, “Is all of this a good thing in the larger sense?” There was a presumption, explicitly stated at a lunch I attended, that all of this was irreversible, inevitable; anyone proposing limitations or regulations was, at best, out of touch or, at worst, actively holding back the forces of progress.

One of the questions I asked, which never got an answer that I found convincing, is why efficiency is the paramount goal. The answers I did get dealt with liquidity, with the ability of traders to make money, with the need to get faster and faster. No one really dealt with the benefit to the larger economic system of which financial markets are a part.

The costs of this Red Queen’s race for speed are becoming increasingly apparent. Multiple breakdowns of exchanges and trading platforms. Collapses of companies when their trading algorithms go rogue. The pursuit of individual corporate profit within the system has started to erode the overall social benefit.

After the last Nasdaq shutdown, I wrote about how it wasn’t a particular concern, but how the increasing rates of failure within the systems were becoming a larger concern. Listening to the panels and participants at the conference, I have a much better understanding of how this process is occurring—and why.

Right now, the goal is to optimize the system around efficiency, around speed and liquidity. This necessarily requires technology. To paraphrase a woman from a private exchange company, who sat with me at lunch, technology and complex systems will unavoidably have failures and breakdowns. It is just a cost of doing business.

Fair enough. There are other things we can optimize for besides speed, however, and I would argue it’s time to look at them. From a societal point of view—and remember, capital formation and allocation of capital is the real reason markets exist in a society—what additional benefit will be created with more speed and liquidity? Will a society with nanosecond trading capacity really outcompete us, with microsecond capability? Why?

If the societal benefit of more speed isn’t demonstrable, and the costs are apparent and growing, then perhaps we should take some time to optimize around reliability, for instance. Take nuclear power as an example of a technology that offers real benefits—carbon-free electricity—but also presents undeniable potential for systemic damage though technology failures. In this case, society has prioritized safety over the benefits.

Make no mistake: the potential for real, systemic damage resulting from failures in the financial system is real. 2008–2009 should have shown us that; since then, the flash crash should have reminded us.

I’m not against technology, in any sense, but I do see a need for responsible consideration of the broader context here. It’s not the job of the companies involved to take that perspective, so, preferably, we need industry bodies to impose self-regulation—before the governmental regulators arrive. The more front-page shutdowns happen, the more likely government intervention becomes.

Technology isn’t the real inevitable here—the government is. Without self-regulation, the feds will show up, and it is to everyone’s advantage not to let that happen.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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