Knight Capital: Just a Warm-Up For the Big One?
Anyone betting that the global financial system will continue to muddle along indefinitely deserves to reap the whirlwind that’s coming. As the rest of us well know, the international banking system is being kept afloat solely by political lies, stupidity, corruption, greed and, most of all, egregiously misplaced confidence. It would seem to be only a matter of time before the rotted timbers of this belief system give way. But what will be the catalyst? The possibility or even likelihood that the financial system will be toppled by some event no one was expecting was an implicit theme of Nassim Taleb’s widely read 2004 book, Fooled by Randomness. In the New York Times, Taleb asserted the following: What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.
In the seven years since Taleb’s book rose to the top of the bestseller list, any number of factors could have caused the banking system to implode but did not. Thus has the passage of time strengthened his thesis by challenging still-widespread expectations of a collapse “any day now.” The possibility has not been negated, of course, but it seems increasingly unlikely that any of the well-known dreadnoughts that have been bearing down on us, including the Mayan calendar’s prophecy of the end of days, will terminate economic life as we know it. For in fact, the financial system has survived the de facto bankruptcy of Europe; a U.S. budget deficit now growing by more than a trillion dollars a year; the collapse of real estate prices in the U.S. and around the world; intractably high unemployment nearly everywhere; and “austerity” enough to push Europe to the brink of Depression. And yet, here’s the U.S. stock market on yet another bullish tear, ignoring all of the bad news to focus instead on the latest drivel from the ECB’s Draghi. In a sane world, Draghi’s words would go unremarked, and those who believe the central banks can reverse the collapse of, for one, a quadrillion-dollar financial derivatives bubble would be intellectual exiles.
So what will finally topple the house of cards? The answer probably lies no farther from us than Knight Capital’s near-death experience last week. One of the biggest players in the trading world, the firm’s computer’s went berserk and lost a reported $440 million in just 30 minutes. Two scary facts should not be lost on those who breathed a sigh of relief when Knight was rescued over the weekend by a group of erstwhile competitors. First, the entire edifice of global banking is hard-wired to the markets in exactly the same way that Knight is, driven by algorithms that are too quick to be overridden by humans. And second, the catastrophic failure of this fragile network seems all but inevitable. Indeed, it keeps happening over and over again on a smaller scale – first with the May 2010 Flash Crash on Wall Street, then with several other high-profile computer failures, one of them involving a programming error that botched the IPO for BATS Global Markets, a firm that had built its reputation on systems expertise.
“Rogue algorithms” have gotten most of the blame, but even those who have created them cannot claim to know what to do about it. Slow the markets down? It’s being talked about, but that would be like trying to control a rabid dog with tranquilizers. Speed has been bred into the DNA of global markets, and there is no going back. When a rogue instruction finally capsizes a market perhaps a hundred times the size of the one Knight was trading in, the devastation will be unstoppable. At that point, we will have unleashed a “monster from the id” like the one in the 1950s sci-fi movie Forbidden Planet. Loosely based on Shakespeare’s The Tempest, Krell civilization had designed an infinitely powerful reactor that could materialize whatever they desired. What they failed to reckon with was that the machine materialized murderous demons from their primitive subconscious while they slept. Will the vastly powerful computers that facilitate lightning-fast trading on the world’s exchanges similarly run amok and destroy their creators?