Focus on Mitigation Rather Than Elimination

Watching the first installment of the History Channel’s The Men who Build America series earlier this week, started me to think about today’s market structure and how it deals with dislocations.

All of today’s market regulation came about to prevent would-be magnates from manipulating the markets and creating their own monopolies like Cornelius Vanderbilt and John D. Rockefeller did during the Gilded Age’s laissez-faire economy.

Today’s regulations and their antecedents helped grow and create new financial markets, but they never, and will never, eliminate the desire by some to push the rules and technology to and past their limits to reap the greatest profits. They are not concerned about the long-term health of the markets. It’s about getting in and getting out with as much cash as possible.

No amount of regulation will extinguish this drive. It is the nature of the beast to have booms, busts and growth. There will never be a point when “this time it’s different.”

Some might say adopting new technologies would solve this by identifying and stopping situations before they could escalate into full-blown crises. Yet for every benefit new technology brings, it also brings a new set of problems that are not fully understood.

During the US Securities and Exchange Commission (SEC)  technology roundtable on Oct. 2, Dr. Nancy Leveson, professor of aeronautics and astronautics and engineering systems at the Massachusetts Institute of Technology, gave a wonderful engineering presentation on why perfect systems do not exist. She then went on to describe how other critical industry regulators like the Federal Aviation Administration (FAA) and the US Nuclear Regulatory Commission (NRC) deal with their respective’s industry’s technological risk.

In short, they make sure that the critical systems within their respective industries consist of only the components absolutely necessary to do the necessary task. Then they go back, test and re-test to make sure everything is beyond bulletproof.

It would be great if the capital markets would follow suit. Many market participants large and small take their trading and technology due diligence extremely seriously and make the necessary investments. Yet some firms either simply get their risk/reward calculations wrong or have a higher risk appetite than others.

No matter in which industry, capital markets, aviation or nuclear power generation, technology breaks; order acknowledgement systems fail; planes crash and reactors… well you get the picture.

The difference between the financial markets and the FAA and NRC is that the latter regulators have their incident and post-incident policies down to a science, according to Leveson.

In every recent financial crisis, the financial industry addressed them on an ad hoc basis, which never gives the best results.

The industry needs to needs to organize a standard response method to mitigate an incident’s damage while still deploying processes like pre-trade risk checks and limit-up/limit-down to avoid potential situations.

It’s just a matter of basic crisis management. Regulators, markets and participants need to prepare strategies to deal with likely market dislocations before they happen, address cross-market effects and drill repeatedly.

Yes, the industry will make mistakes along the way. The FAA and NRC did not reach their level of response proficiency overnight, which makes thorough incident post-mortem all the more important. What things can be learned from how the industry addressed the Flash Crash? What should be done the next time and what should not be done?

The faster and more efficiently the industry can respond to an incident addressed, the better it is for all involved.