http://www.ft.com/cms/s/0/845a29aa-5eef-11df-af86-00144feab49a.html
May 14 2010 Financial Times
Risks posed by get-rich geeks are not just a flash in the pan By Gillian Tett
Last year, I bumped into a brilliant mathematician friend who had spent much of the past decade grappling with complex credit. Ruefully, he confessed that he and his fellow geeks were starting to find products such as credit derivatives rather dull.
For the banking crash had left investors so nervous and regulators so heavy-handed that there was little scope to be "creative" any more. Indeed, he questioned whether those products would really last (which looks rather prescient, given some American politicians are now intensifying efforts to ban naked shorts in the credit default swap world).
But some eggheads, he added, had a fall-back plan. As credit derivatives became boring, some of those players were moving into algorithmic trading instead. For that area still apparently offered scope for intellectual innovation, and, of course, fat profits. "It's a real frontier," he said, with glee.
It is a tale that regulators on both sides of the Atlantic should note. An entire week has now passed since the extraordinary, tumultuous crash and rebound of the US equity markets. But, although regulators and policymakers have been crawling all over these events with a toothcomb for seven days, the only thing that is even more remarkable than the drama of those events is that their trigger remains a mystery.
Reflect on that for a moment. A regulated public equity market crashed dramatically, prompting a full-blown enquiry, but thus far policymakers appear mystified by the cause. It might have been a "fat finger error," a computing malfunction, or a rogue trader. But, then again, it might not. The only thing that is clear is that the structure of the trading systems, with all their high-speed, computer-controlled practices, appears to have magnified the problem in a way that caught regulators, bankers and investors by surprise.
Ironically enough (or perhaps not so oddly, given my story about the geeks) this has numerous parallels with the world of complex credit. During the past decade, algorithmic trading -- just like complex credit a few years before -- has expanded at a dizzy speed. However, until last Thursday, this activity was largely ignored by the wider world.
That was not necessarily because algo traders deliberately wanted to hide their craft (though some certainly did); instead, a more subtle problem was that this activity seemed to be so mind-numbingly geeky and dull to ordinary mortals that very few journalists, politicians, or even regulators, had much interest in asking hard questions.
When traders spoke about their risk-management systems, using the language of advanced maths, most non-bankers simply switched off. In any case, all of this activity was wrapped up in rhetoric that suggested that financial innovation in the trading infrastructure was a good thing, since it promised to make it more stable, liquid and "advanced." Which, of course, is what people also said about collateralised debt obligations.
Now, of course, it is painfully clear some of this rhetoric was dead wrong. Just as regulators discovered back in 2007 that credit securitisation had built interconnections and fragilities across the financial system that nobody understood, so too the rise in algo trading has introduced new interconnections -- and extreme fragilities, which are poorly understood. A 21st century financial machine -- or monster -- has emerged, which appears to have spun out of the control of government (or anyone else). Little wonder that recent opinion polls suggest public faith in finance and government is slipping.
This has at least two important implications for regulators. In the short term, it is obviously extremely important that regulators now try to determine exactly what happened last week, and then explain it in language the public can understand. Slapping on a uniform system of circuit breakers, or imposing other regulatory curbs might help, but only to a limited degree. What is needed now is a full explanation of what happened.
But the second big lesson is that regulators now need to become a lot more creative and proactive in monitoring the financial system. In recent years, supervisors have created numerous rules in an effort to stop the financial system spinning of control. They are now creating even more of these, while also attempting to improve the data they collect on market trades and prices.
But while some of those reforms are welcome, there is another more basic step that regulators should also take. They should start watching which financers are collecting the fattest pay cheques and where the real brains in finance are heading and then allocate their resources towards monitoring that field. Even -- or especially -- if that area looks distinctly dull or geeky, be that in the trading world, credit or something else altogether.