Thursday, February 17, 2011

The Future of Finance is Getting Closer

I know that not all of these facts that I present below are new, but reading about the following five in the morning papers just reconfirmed my position on the future of the financial markets.

First and second, stock exchanges have become dominated by high-frequency trading and index funds.

Third, the combination of the Deutsche Bȍrse and the NYSE Euronext will continue the trend for exchanges to turn to derivatives and technology business. The model here seems to be the CME Group, “the world's leading and most diverse derivatives marketplace” which has a market capitalization that is larger than either of the two combining institutions.

Fourth, the Shanghai Stock Exchange and the BM&F Bovespa, Latin Americas largest exchange is going to announce an agreement which will include the fact that stocks will be cross-listed on both exchanges. This will put Brazilian and Chinese interests together, world-wide.

Fifth, the IBM computer named Watson beat the two “greatest” players on the TV program “Jeopardy!” This, of course, comes only a few years after an IBM computer beat the world champion of chess at his own game. And, this most recent battle of “wits” has set off a plethora of articles on the state of artificial intelligence. The advances are mind-boggling!

A sixth fact could be the unrest in the Middle East where a very serious challenge in being raised against local autocratic leaders. Part of the cause, information technology.

Why are these “facts” important to me?

They are all just another indication the spread of information and information technology continues and cannot be stopped. Not only are things happening faster, they are becoming more ubiquitous.

Once again, for those that have not yet read the book titled “The Quants”, you should because it gives us a glimpse of what the future is going to be like. (See my review:

And, this is the world that Congress (and other bodies around the world) is trying to regulate?

But, regulating to prevent 2007 and beyond from happening again is not going to protect usin the future.

It is the world that Mr. Gary Gensler, the chairman of the CFTC is trying to get his arms around and control.

But, how do you grab hold of a “whiff of smoke”?

The above facts are dramatically showing that finance is information and that the storing, processing, analysis, use and dissemination of information is going to become more and more technologically advanced as time passes. In fact, it is going to happen faster and faster.

In the future, more and more finance is going to be “quantified”; trades are going to occur at even greater speeds; and information is going to be stored…somewhere…and transactions are going to happen…well, someplace.

Regulation cannot just focus on “outcomes”. Regulation cannot eliminate “systematic” risk.
Furthermore, regulation of the kind we are used to in the United States only takes place “after-the-fact.”

The only way to really gain some insight into what is going on in financial markets is to observe what the market is saying. That is, the only way to get some kind of “advance warning” about market trouble is to watch market information.

Such systems have been suggested. One such suggestion has been given for an “early warning” methodology for the banking system. I have discussed this methodology in several posts over the past year. I will refer to just one of these posts ( that references the work of Oliver Hart and Luigi Zingales. The system proposed by Hart and Zingales is a market-based system that can raise “red flags” that regulators can respond to. In this way their system is “anticipatory” and not “reactive.”

Still, this world of the future must avoid some of the problems of the past. No regulatory system is going to be able to survive a regime of undisciplined governmental policy like we have seen in the United States over the past fifty years. Credit inflation undermines an economy and destroys discipline. (See my post

This must be considered within a world that is going through a period of transition that is monumental. Major shifts are taking place everywhere and we really don’t know what the ultimate result is going to be. However, we are moving away from a “labor”-based, manufacturing system to a “knowledge”-based society embedded within whatever the current information technology allows. The government cannot continue to base macro-economic policy on the assumption that the structure of the world still rests on the old, labor-based manufacturing system. It will just perpetuate the errors of the past.

As advancing technology allows us to do “finance” faster and in more ubiquitous ways, the techniques and tools of finance will just be used to take advantage of the credit inflation created by governments. Remember it is the wealthiest, the most trained, and the best positioned that will be able to take full advantage of the incentives created by further credit inflation.

What proof do I have for this?

Take a look at the last fifty years of credit inflation. What have been two of the fastest growing sectors in the economy?

The answer is: information technology and finance. And, these two sectors have complemented each other very well. Computer-based financial innovation has thrived in this environment of credit inflation. In fact, no other environment is so conducive to financial innovation than is an environment based on credit inflation.

And, the results of the past fifty years?

The purchasing power of the dollar has declined by about 85%. Under-employment of the working force is somewhere in excess twenty percent. And, the income distribution has become radically skewed toward the wealthier end of the scale. Need I say more?

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