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Blow-ups in Technology-boosted Finance

February 9, 2016 • Posted in Big Ideas

Has the Moore’s Law-driven advance in financial information technology strengthened the hand of Murphy’s Law in markets? In the January 2016 version of his paper entitled “Moore’s Law vs. Murphy’s Law in the Financial System: Who’s Winning?” Andrew Lo reviews big unintended consequences of technology-leveraged finance including fire sales, flash crashes, botched initial public offerings (IPO), catastrophic algorithmic trading errors and access failures. He then discusses the counterbalancing roles of technology in elevating and suppressing financial system risk. Based on a survey of recent financial system breakdowns and his experience, he finds that:

  • A financial analog of Moore’s Law is that the volume of exchange-traded derivatives doubles about every five years.
  • This exponential growth drives a complexity/interrelatedness that amplifies instances of Murphy’s Law in the financial system. For example:
    • Quant Meltdown in August 2007: Financial innovation widely adopted among hedge funds encouraged similar portfolios. Sudden unwinding of these “independent” portfolios drove large price impacts and commensurate fund losses.
    • Flash Crash in May 2010: An automated selling program in the futures market cascaded across U.S. financial markets.
    • BATS and Facebook IPOs in March and May 2012: An infinite loop between high-speed new orders and automated calculation of the opening trade price drove extreme prices, an interaction not anticipated in hundreds of hours of pricing system tests.
    • Knight Capital Group in August 2012: An unlimited surge of accidental electronic orders generated huge losses, resulting in acquisition of the firm by a rescuer.
    • Treasury Flash Crash in October 2014: A seven-sigma intraday pricing event occurred still with no clear explanation.
    • Bloomberg Terminal Outage in April 2015: A combination of hardware and software failures disconnected hundreds of thousands of serious traders for two and a half hours, essentially freezing some markets.
  • The common theme is that technological innovation tends to coordinate the responses of panicked investors to unexpected losses, manifested as flights to safety, rapid price declines and/or liquidity evaporations that are impossible to contain. Such disruptions can occur when all systems are operating “normally” (as designed).
  • The ultimate solution is more technology that robustly adapts to human foibles.

In summary, new forms of financial systemic risk emerge as technology-driven system activity grows exponentially with increasing interconnectedness, thereby increasing system complexity.

Cautions regarding findings include:

  • The prospect of an ultimate balance between technology-driven disruption and technology-driven stability is not obvious.
  • Some of the technology-driven unintended consequences may be opportunities.

 

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