Sunday, October 3, 2010

A Commentary on the Joint CFTC-SEC “Flash Crash” Report

I have been busy lately reading and rereading Hegel; what he wrote and what is written about his philosophy. I had to. Writing a volume on Dialectics of Finance demands having a dialectical method at one’s fingertips and I noticed in certain places I wasn’t up to par. Hence, the need for going back to the original source.

Hegel purports to explain the world. That’s a tall order. To that end, one must first explain what is meant by “explanation”. At what point, when or how, will we know that the world is satisfactorily explained?

The apparent way of explaining something is pointing to its cause. If we know A is caused by B, then we say that the cause of A is known, or A is explained. The cause of boiling water, for example, is heat; it boils when it is heated to 100 degrees Celsius.

But the world cannot be explained in this manner. Assuming we could show that A is caused by B; B by C; C by D, etc., the last phenomenon – “the first principle of the world” – by definition, will have no cause because it is prior to everything else. The last cause of the world, therefore, would remain a mystery, which means that our entire explanation would revolve around a mystery. That is no explanation.

Upon closer examination, we realize that the cause and effect provides no explanation even for everyday phenomena. Water boils at 100 degrees Celsius. Why? We do not know. It is a fact that dogmatically asserts itself and which we have observed millions of times. But why it should be so, no one knows. No amount of logical thinking could lead to boiling water from the idea of heat. Heat could as well result in water freezing. Knowing the intermediate steps will not help a bit. Suppose we know that heat results in water boiling because, as a result of heat, the speed of the atoms’ electrons around the nucleus increases. The question would still remain: why should heat increase the speed of electrons – and not, for example, cold?

Take the famous example of evil. As Stace explains in his Philosophy of Hegel, suppose we know that the cause of evil in the world is a virus; never mind its implausibility. But even if we knew the cause of evil, it would still remain a mystery. We would still not know why it should exist.

From this, Hegel concluded that the meaning of explanation is providing the reason for it. That is, the “explanation” of a phenomenon is not providing a cause of which the phenomenon is an effect but a logical antecedent of which it is the consequence. Nothing further is needed because reason is a self-explanatory process. Stace writes:
It is of the essence of reason that its entire process is necessary. Nothing in it can be arbitrary of accidental. It does not begin and end anywhere. Its progress if fixed by its own rational principles and cannot be altered by our individual whims ... The essential character of reason is necessity.
I thought of all this because on Friday, the joint CFTC-SEC Findings Regarding the Market Event of May 6, 2010 was released.

I knew about the project. I knew it was being led a physicist who had promised that his investigation would “zero in on a specific sequence of events that preceded the crash.” I knew from reading Hegel that such clerical reading of the events would explain nothing.

Well, they do not.

The report is a clinical, blow-by-blow description of the events preceding the crash, without saying why the things happened. Here is an example:
At 2:32 p.m ... a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

Generally, a customer has a number of alternatives as to how to execute a large trade ... This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.
Does this mean that if the customer had chosen to transmit his sell order via other alternatives, there would not have been a crash? The report uses “without regard to price or time” to insinuate something sinister. But that is the description of one of the most common orders in the market. When you pick up the phone and instruct your broker to sell 1000 shares of IBM at the market, that is a sell order without regard to price or time.

The report’s failure was preordained. Now, I could count the reasons, but the list is legion and will take time. Better for me to return with my take on the subject. It should be easier to explain the problem rather than pointing out the errors of a long report.

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