Systemic Risk

From Jared Dillian:

The reality is that when you have someone in a privileged position where they can see order flow and position themselves accordingly, they will surely take advantage of it—human or computer. For a number of reasons, I’d rather have the computers.

Except for this: the problem with the current system where a few large firms, electronic trading firms, act as liquidity providers is that they actually centralize, rather than decentralize, risk.

They take small risk (a bunch of little orders) and turn it into big, concentrated risk. Now, electronic trading firms are not in the business of taking big risk—they are in and out of it very quickly, so it’s unlikely that they’d willingly strap on a big position. But a few years back, Knight Capital had a catastrophic trading error that resulted in them having to be bailed out by a group of independent investors.

What if that happens again—even bigger?

It’s actually a general principle that things work better when you break them down as small as possible. This is the principle the United States is founded on—that states and municipalities retain political control.

Problem is, we’ve been concentrating risk everywhere since the financial crisis. I don’t care who you think was responsible for the crisis, the net result of our interventions is that the banks that were too big to fail in the first place are now even bigger. I don’t think that’s progress. I don’t think it’s progress that if anything goes wrong, we put it on the government’s balance sheet.

If I were in a position of authority in the government, I’d spend my time looking for ways to break down risk to the smallest unit possible.

But that’s not what we’re doing. We’re going around looking at things like mutual-fund companies and calling them SIFIs (Systemically Important Financial Institutions) and then regulating them, which will only make them more systemically important. Dumb, right?

What are the chances that we are going to have another big crisis as a result of this? 100%.

It’s not just anti-capitalist, that is, cronyism, to set up certain companies to be SIFI, but it’s also a path to more, not less, pain.

Add this together with previous posts on market drops and debt, and market price momentum, and an argument can be made for a economic perfect storm.

 

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