Deus Ex Machina: The Rise of a Fully-Automated Regulatory System

Thu, Nov 13, 2008 - 12:00am

Imagine yourself living in 20 BC watching a Roman play among hundreds of other faithful citizens in the cool temperate air of Asia Minor. The plot has been taking numerous twists and turns, becoming progressively complex, and it now seems that it has reached a climax. No one in the audience has any idea on how the story will resolve itself and it seems that everything has led up to a situation that is so tense and chaotic that everyone is either on the edge of their seat or biting their fist. It is at this point where many hope for some brilliant stroke of genius or the triumph of the story’s characters against all opposing odds. Instead, a man draped in flowing robes with a crown on his head is lowered from over the stage by a wooden crane; he is “Zeus” and, by divine intervention, magically resolves the story’s insurmountable problems with the wave of a hand. This was called “deus ex machina”, or “god from a machine”, and it refers to the use of a writer to employ this very tool to resolve a plot that has exceeded the ability to work itself out by rational, or human, means.

In terms of where we are today, there is no clearer sign that the complexities of the American economy have swelled beyond the control of the US government than a national debt currently in excess of $10 trillion (and steadily growing!). Add to that hundreds of billions, or even trillions, of dollars spent in order to bail out every major bank and company in the US prevented from going under and we see, in terms of our Roman tragedy, that “the powers that be” certainly consider money to be the divine panacea to fix our broken and failing human institutions. But, then again, money alone cannot solve the problem of the human condition—enter the machine.

For most of human history, money has been a medium of exchange purely between people, or institutions run by people. However, in the past 20 years or so a transition has been taking place that is slowly replacing the people in financial transactions with a far more efficient and sophisticated creature: the computer.

On the front cover of Bloomberg magazine last year ran the title, “The Ultimate Money Machine: Artificial intelligence, once the stuff of sci-fi fantasies, is closing in on Wall Street. A corps of scientists is trying to teach computers to think like traders—and outsmart human stock pickers.” Now before you write everything else off that I’m going to say merely for the mention of AI, let me first point out that this is a legitimate publication, not just some cyberpunk technology magazine. Second, I want you to consider—just for a minute—the possibility that computers, having both the ability to access and process far more information than we could ever imagine, will actually outsmart the best traders and investors in the world.

Most people have the common misconception that artificial intelligence will be a sudden and explosive development, if believed to be even possible at all, however, the process of substituting human intelligence with that of a computer has already been at work for more than 20 years. In the same article I mentioned above it says, “A third of all U.S. stock trades in 2006 were driven by automatic programs, or algorithms, according to Boston-based consulting firm Aite Group LLC. By 2010, that figure will reach 50 percent, according to Aite.” That is, by 2010 it is predicted that at least half of all trading in the US will be done not by people but machines, automated programs that are being created to outmaneuver their carbon-based counterparts. And, as we all know, technology is only getting smarter and faster by the day.

Not only is the reliance upon automated platforms aided by advances in technology, the SEC is also facilitating this transition through very tight regulatory standards. For example, in 2006 Regulation NMS (National Market System) minimized the required time of trade execution from the normal 30 seconds down to 1, making the dependency upon high speed computer-driven orders almost a necessity. Furthermore, with the ability to routinely update trading methods according to evolving regulation the need for huge compliance departments to both implement and enforce such activity is no longer necessary. And given the growing complexities of the market and thus, volumes of regulatory minutiae, it’s no wonder that computers are becoming a dominant feature of the marketplace.

Consequently, there’s another reason why this trend is being facilitated by regulators: the use of automated systems increases the supposed "efficiency" of the market. At one point, you may have learned or heard of the fabled EMH—the efficient market hypothesis. The basic idea is that markets are efficient when all information is reflected immediately in prices. The outcome of this is that no one should be able to consistently outperform the market based on say, insider information. One major set-back to this is the obvious fact that markets are comprised of often very inefficient human-beings. For example, sometimes information diffuses slowly or only to a privileged few, many times people react differently to the same set of information, or markets often react in a surprising and irrational manner. The exceptions to the EMH are systemic with markets being comprised of irrational and inefficient agents, unless you replace them with rational and efficient ones.

So, what is the point of this you may ask? Well, let’s imagine three interweaving scenarios: 1) a majority of all market transactions across the globe are done electronically via automated programs; 2) markets, and the exchanges where these transactions take place, are being largely consolidated; and 3) a single regulatory agency governs this system. Put all three of these ingredients together and, overtime, you may just find yourself living in a world run by a fully-automated electronic regulatory system—that is, a god from a machine. Perhaps this is far-fetched? Then again, with the pace of modern technology so are many things that were utterly inconceivable to someone living just a few decades ago.

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