Saturday, November 28, 2009

IT infrastructure investments

Information technology (IT) infrastructure investments by Wall Street investment firms are approaching $3.6 billion annually. By contrast, the U.S. Commodities Future Trading Commission (CFTC) has an annual IT budget of $23 million--which makes it difficult for them to monitor and regulate derivatives trading. Their servers, bandwidth pipes, storage, and overall IT infrastructures are slow, old, inadequate, and obsolete.

It's analogous to highway patrol squad cars having a top speed of 160 mph, rendering them impotent to catch speeders averaging 1000 mph. The software algorithms and quantitative analysis investment firms perform are fast enough (and getting faster) to stay ahead of the watchdogs.

Financial derivatives are useful in hedging strategies and increasing potential returns on investment, but they can also be weapons of massive financial destruction when leverage is abused. And algorithms can spin out of control when asset bubbles burst. The race to be ahead of everyone else sometimes causes the mutual destruction of algorithms gone bad, as self-fulfilling negative outcomes beget other larger losses.

The regulatory path has become increasingly futile as Wall Street computing capabilities increase geometrically with Moore's Law.

Free market proponents epouse minimum regulation, with a mantra of caveat emptor, but cases of fraud and market manipulation should be regulated and prosecuted to the full extent of the law. Rigged markets and lack of transparency hurt markets long-term, as investor distrust of manipulated markets cause participants to stop trading. Without investors, markets disappear.

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