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Derivatives and Computers

May 10, 2010

The Times has a pair of stories today that are fun to set next to each another. The first one is about lobbying on the financial reform bill. Banks don’t want to be thrown out of the derivatives market because that’s where the profits are.

Watch for Sen. Blanche Lincoln (D-Arkansas) to get pilloried in the allegedly liberal mainstream media starting about now.

The banks have a point, however. If we take them out of the game, that will leave only the deep scammers in it. There are degrees of criminality in the financial world, and the commercial bankers appear to be at the shallow end of that pool. The deep end is dominated by investment banks and hedge funds.

The same point is made in this other story,  ostensibly about last Thursday’s 15-minute stock market panic, during which the Dow plunged 600 points. The trigger-point, once again, appears to have been a derivative:

. . . the earliest sign of trouble they have found was a sudden drop in the value of a futures contract on the Chicago Mercantile Exchange, based on the Standard & Poor’s 500-stock index.

What happened next seems to be a case study in unintended consequences. The traders on the main exchange were suddenly slowed down by a so-called “circuit breaker” rule, which was put in place after the crash of 1987 to arrest computer-driven stock plunges. (Kids, for more on the crash of ’87, see Wikipedia). The circuit breaker rules worked perfectly–where they applied. Unfortunately, the computer traders had long since left the field, and they continued to trade at the speed of light using other, less regulated markets.

Libertarians will no doubt use this example as an argument for less regulation. Their “regulation is futile” line of reasoning is actually their best case. The alternative, of course, is for governments across the world to “man up,” as the saying goes, and bring the twerpy little hedge funders to heel. To paraphrase Thomas Jefferson, “If I had to choose between hedge funds without government, and government without hedge funds, I would not hesitate to choose the latter.”

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