The Witches of Wall Street

Nobody knows why the stock market crashed in October. Nobody knows why it had gone up so far in the first place. Don't believe anyone who tries to tell you otherwise.

Unfortunately, a lot of people will tell you otherwise. And the most ignorant are also the most insistent that we have to "do something" about the market—and that they have just the policy that will fix everything. The mood on Capital Hill, as one Senate staffer described it to the Wall Street Journal, is "Let's burn some witches."

If it's witches you're after, the most likely candidates are people who deal in mysterious numbers, use instruments most folks don't understand, and speak a strange language. In other words, scientists—or the nearest thing to them.

On Wall Street, these people are called "quants" or "rocket scientists." Often mathematicians or physicists by training, they've been drawn to the financial markets by a revolution in the way investors understand securities. Twenty years ago, people looked at the market and saw discrete, completely separate instruments—stocks or bonds or commodities options. Today, they realize that what traders are buying and selling are really the characteristics of risk and return that underly every financial instrument.

Using sophisticated mathematical models, it is possible to find combinations of securities that ought to be equivalent. As Harvard economist Lawrence Summers once put it, modern finance economists are like catsup experts who spend their time proving that a 12-ounce bottle is equivalent to two 6-ounce bottles.

This pursuit sounds stupid, which is how Summers intended it, but it has two important applications. First, by finding cases where equivalent securities aren't priced the same—where two 6-ounce bottles are cheaper than one 12-ounce bottle—investors can make money by buying or selling accordingly, until the prices equilibrate. This type of arbitrage has made the financial markets more efficient.

Secondly, and more relevant to the current debate, investors can reduce the risk of any given security by finding an equivalent and hedging their bets. Or they can find an instrument that is equivalent in some respects but not in others. For example, if you want to bet on a company's good management but not on interest rates, which also affect stock prices, you might buy both the stock and an interest-rate call option whose price will rise if interest rates go up and drive down stock prices.

In response to such demands, investment banks have bundled together nearly every imaginable combination of financial characteristics to produce an amazing array of new financial instruments. And computer programs have been developed to find and exploit arbitrage opportunities and to trade off different types of securities as market conditions change. The result has been a speed-up in the flow of information—and in traders' ability to respond to it.

All of this is pretty complicated and involves (horrors!) both math and computers. And, as the all-too-true truism goes, people fear what they don't understand. So it isn't surprising that politicians and other financial Luddites have responded to the crash by calling for restrictions on both computerized "program trading" and such newfangled securities as stock-index futures.

But loose talk about crackdowns is as dangerous as it is ill-advised. The government is the most powerful player in the market; its economic policies affect every type of security and it alone can obliterate a market by decree. Earlier this year, for example, investors lost more than $2 billion when the Bank of England wiped out the market for a London-based security called "perpetual floating rate notes," or perps. When U.S. politicians threaten securities here, they're likely to reduce liquidity and drive prices down further.

More fundamentally, what politicians are trying to do is impossible, stupid, and wrong. They want to put the financial genie back in the bottle, to outlaw information and force investors to unlearn truths about how securities work.

But today's financial markets are very hard to regulate—a fact mournfully noted by many a reporter. They are complicated and, more importantly, they are international, beyond the jurisdiction of any one government.

As former Citicorp chairman Walter Wriston has noted, if the United States outlaws new financial instruments or program trading, investors will simply go abroad to freer markets. "That system wasn't built by economists," he told the New York Times. "It was built by technology and it isn't going to go away."

It won't go away because even the most esoteric securities perform useful functions for investors. They have passed the most basic market test—investors want to buy and sell them. If they can't do it in New York or Chicago, they'll go to Tokyo or Hong Kong. It's just a question of who gets the commissions.

Remember, nobody knows why the stock market crashed. It might be because Congress threatened to tax takeovers. Or because of the deficit. Or fears of a trade war. Or the Fed. But trying to make the market go up by outlawing trades is like trying to cure a fever by shoving a thermometer in an ice bucket.