The recent discussions surrounding Michael Lewis’s new book, Flash Boys, revealed a profound and uncomfortable truth about modern finance to the public and policymakers: Machines are taking over Wall Street. Artificial intelligence, mathematical models, and supercomputers have replaced human intelligence, human deliberation, and human execution in many aspects of finance. The modern financial industry is becoming faster, larger, more complex, more global, more interconnected, and less human. An industry once dominated by humans has evolved into one where humans and machines share dominion.
In a new article published in the Alabama Law Review, I examine this transformation and the regulatory principles that should govern it. Building on my previous research in this area, the article offers one of the first systemic examinations of this ongoing financial transformation and presents an original set of regulatory tenets for governing the emerging, new financial industry. It normatively and descriptively traces the journey of this financial transformation, highlights promising and perilous paths, explains current regulatory shortcomings, and proposes new guiding principles for the road ahead. The article attempts to map the path of modern finance and financial regulation, from the recent past to the ongoing present, so as to provide an early guide for the emerging future.
The article presents this dynamic cartography of modern finance and financial regulation in five parts. Part I charts the road traveled and the road ahead. It offers a retrospective on how technological advances and financial innovations have transformed the financial industry into a new industry that is faster, larger, more complex, more global, more interconnected, and less human. It then previews key attributes of the emerging, new financial industry relating to technological progress, traditional financial structures, the growth of “shadow banking,” and the role of humans in the future of finance.
Part II highlights threats along the way. It reviews the Flash Crash of May 6, 2010, which, in minutes, destroyed nearly $1 trillion in market capitalization. It forewarns of similar crashes in the future given the increasing reliance of finance on computerized systems. Part II then discusses new crimes and perils as the new financial industry migrates into cyberspace on a grand scale. It warns of threats posed by hackers, spies, criminals, competitors, and other nation-states.
Part III foreshadows new systemic dangers. It asserts that the enhanced speed and interconnectedness of the new financial industry presents two underappreciated systemic risks of speed and connectivity. The risk relating to speed is termed “too fast to save,” and the risk relating to connectivity is termed “too linked to fail.” Part III argues that these new systemic risks will be at least as challenging and pressing as the widely recognized systemic risk of “too big to fail.”
Part IV contends with structural pitfalls. It identifies fundamental shortcomings in the current regulatory framework that render law and regulation unsuitable for better monitoring finance under the prevailing governance model. Part IV explains why core matters relating to jurisdiction, origination, and resource prevent regulators from effectively governing the emerging, new financial industry.
Part V offers a new way forward. Mindful of the perils and pitfalls articulated in the previous Parts, it proposes an original set of regulatory, first principles to better harness the potential and promise of the changing financial landscape. The principles include enhancing disclosure, encouraging smart private regulation, promoting self-insurance, customizing regulation, and building automatic reviews into new rules, among others. These proposed tenets address issues fundamental to financial regulation including effectiveness, transparency, speed, coordination, bailouts, costs, and accountability. Part V concludes with a reminder that the proposed tenets should serve as principles of regulatory design for policymakers as they embark on the difficult and important task of re-imagining and rebuilding a better, workable framework for the emerging, new financial industry.
The full paper is available for download here.