Friday, December 09, 2016

The deregulation fetish nudges us closer to the brink

I noticed two news items today which point towards the dynamics alluded to in the last post.

Christopher Giancarlo is increasingly becoming the dominant voice in the CFTC. Here he is opining about the inability of commodity derivatives traders to actually get any collateral set up for the bulk of their transactions by *March 2017* - he thinks they will not be able to make it by the deadline set in the reform proposals created in the last eight years. On the face of it - Giancarlo - who everyone seems to think will succeed Chairman Massad as head of the CFTC - supports the basic ideas of the Dodd-Frank Act of 2010, but says " the agency should look beyond mandates from the 2010 Dodd-Frank Wall Street reform law to current trends in financial markets" - In those trends he finds cyber threats, liquidity risk, market concentration and de-globalization. 

Another interesting aspect of this approach to making American derivatives markets "competitive" again is an emphasis on Blockchain and AI guided transactions. On the face of it - this seems like a great idea - but in reality - it takes a very different form.  Let us examine what these terms really mean.

The Blockchain concept is only really understood by a small group of people. This information asymmetry is IMHO the root of the problem. While Blockchain is supposed to democratize the information in theory - in reality it reduces trace-ability and creates often invisible barriers to accountability.

At its core - Blockchain represents a decentralized and transparent ledger. There is no limit to the size of the ledger and access to it cannot be cut off by compromising any portion of the ledger. The ledger is maintained independently, has redundancy and has a high level of fault tolerance built into it. So far this sounds great - every time a trade is made or a contract is entered into it is recorded in this ledger and no one can erase it. Everything is electronic - so at the click of a button - we can all become part of the blockchain. This should make the market a better place right?

Well - not really - merely having a great ledger doesn't mean that all transactions are traceable. The most prominent example of a blockchain is Bitcoin. Blockchain is the biggest factor underlying the success of Bitcoin - specifically you can't use the same bitcoin to make two transactions (at least in theory). Once you buy something with a bitcoin - you transfer it into someone else's wallet and they own it from that point on. However try tracing a bitcoin's transaction history or the owner of a bitcoin wallet and you immediately run into a serious problem. Given how distributed the database is, unless the bitcoin owner wants you to know who they are - it can become highly challenging to trace them.

If Blockchain approaches are applied to derivatives trading, then as long as the derivatives are traded on an exchange or at a place where the can be accessed and coupled to some kind of informative IP search - everything should be fine. But if you do these trades off the market - then unless everyone involved in the trade is willing and able to share the information about the trade - it is untraceable. This kind of thing goes on today, however without all the push-button convenience - it is a much slower process which allows for human intervention preventing extremely stupid stuff from happening.

The point about human intervention applies equally well to AI guided trading strategies. In this electoral cycle we have seen humans fail to separate facts from fake news. What would make an AI any better at doing that? AIs still come up short on benchmark problems like image recognition and the rate of false positives and false negatives is quite high. The only thing that can guide a HFT algorithm is an AI. No human can keep pace with those HFT algorithms. If the AI gets it wrong, the HFT algorithm will too. The humans maintaining the AI will only be able to judge its performance by the false positive, false negative and accuracy numbers. As long as those are within published limits elsewhere in academia - they will be able to reasonably claim that their approach is state of the art. They will keep their jobs - even if you lose everything you own on the market.

Again - a regulated form of Blockchain and AI guided trading is perfectly acceptable to me. The regulations and thresholds will always be arbitrary but they will be necessary for keeping people in this line-of-work honest.

Absent that regulatory framework - we are heading straight for the abyss. 


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