Introduction
This article was first published in Quantum magazine.
The financial sector operates with a speed and complexity inconceivable a generation ago and many regulators and politicians blame these changes for the recent global economic crisis. But ultimately they will create a more efficient and fairer system.
How It Used to Work
Only 40 years ago, it was pretty easy to understand the global economy and the financial system that enabled it to operate efficiently. Most activity was controlled by direct forces of supply and demand, and could be understood by anyone who had been to a bazaar.
There were simple, direct economic linkages. Merchants looked at store shelves and phoned re-orders in to wholesalers who looked at warehouse stocks and phoned re-orders to distributors who relayed demand to manufacturers who planned production schedules accordingly. Transactions were mainly exchanges of goods or services for cash or short-term credit.
Financial institutions were well-established and uncomplicated, as were the few financial instruments they used. A few people worried about what was called “high finance,” which included the complex details of government and international economic linkages, but this was a minor froth on the great tide of economic activity.
Take the example of buying 100 shares of General Electric stock. In 1970 it was done by real people in real places. The purchaser called a stockbroker, who called a floor-trader, who delivered the order to a specialist on the New York Stock Exchange floor. The specialist wrote it down in a book, with a pen. He might match the order up, by hand, with a seller; or either he or another floor-trader might provide liquidity by selling the stock to the purchaser for $80 and buying it later from someone who wanted to sell for $79.875.
Computerized Trading
Today the order would probably be entered into a computer, using one of many alternative interfaces, and then be routed by a complex process the investor does not understand to some virtual place. Along the way it sparks a flurry of high-frequency trading. Somehow the purchaser’s order gets “filled,” but it’s impossible, even after the fact, to determine who sold the shares or who provided the liquidity.
No single human understands the entire system, and it can do mysterious things. However it is far better than the system it replaced, handling many more orders far more quickly, accurately and fairly, at much lower cost, and there are much better controls. There are also many fewer errors, but when these do happen—such as the May 6, 2010 “flash crash”—the response is one of fear, because it is impossible to understand how the errors occurred.
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