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Thursday, October 23, 2008

Should Worldwide Stock Markets Stop Electronic Trading Using Algorithms?

We’ve entered the age of the Algorithm, which is the age when computer programs run and make decisions that affect our lives. These Algorithms have already become quite good at beating most experts at games such as chess, poker and checkers, but there are others that can also beat the common investor in stocks. Currently we’re witnessing the Darwinian battle of the remaining Algorithms in the trading of stocks. These successful Algorithms have made a great deal of money for their investors, so there is a reluctance to abandon them, but we are in unique and unprecedented times that require us to think about the higher order effects on the overall equilibrium and stability of the global markets.

Many successful Hedge funds have used stock trading algorithms to make billions of dollars. Now that many investors have learned that the way to make a small fortune in the stock markets is to start with a larger one, these trading algorithms are left and pitted against one another. However, there are flaws with regulators allowing these scenarios to be played out. One flaw is that the overly successful algorithms will extract billions of dollars in wealth out of the markets. Any market strategy that wins repeatedly will eventually ruin the markets for everyone else. This has to be recognized by the market regulators and eventually corrected in order to maintain orderly markets.

Previously, some market rules and regulations may have functioned as brakes on the rapid electronic trading using these algorithms. Unintended consequences that may have made algorithmic trading more difficult may have resulted from the suspension of these rules such as the uptick rule. These have to be carefully considered by market regulators as necessary brakes on these powerful funds.

An interesting evolutionary perspective from these epic Darwinian struggles suggests that it isn’t necessarily for the best to eliminate all competition in evolving systems. Of course this raises many questions, such as: “What is the best?” and “What is the purpose of evolving systems?”, that can’t be answered here in terse and nonphilosophical words. Even the purpose of competition, itself, becomes a philosophical conundrum in this context, so I should stop here.

Saturday, October 11, 2008

Credit Default Swaps and the Financial Crisis

A couple months ago, most of us never heard about credit default swaps (CDS), but now we learn that they may be at the heart of the financial crisis. This is primarily because many banks and financial institutions have credit default swaps on their books and no one knows how to value them or how much these financial institutions may owe.

According to Wikipedia (

A credit default swap (CDS) is a swap contract in which a buyer makes a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default or on the occurrence of a specified credit event, for example bankruptcy or restructuring. The associated instrument does not need to be associated with the buyer or the seller of this contract.

Estimates of the credit default swap market has grown to the tens of trillions, (yes, that’s trillions), of dollars. It is now estimated to be larger than the world’s GDP. This has caused many institutions to hoard cash and not lend to others for fear that many have these “toxic debts” on their books.

Why don’t we make credit default swaps illegal? They will always remain as a source of doubt about financial institutions. Those who’ve engaged in these unregulated practices will just have to eat their loses, which they appear to be doing now. Just look at the recent auction of Lehman Brother’s credit default swaps, which yielded about 8 cents on the dollar. Wouldn’t we be better off legislating them all away and starting again from zero?