‘Markets’ infrastructures matter.’  That sentence is as important – and brain-wrenching – for the 2010s as Marshall McLuhan’s phrase, ‘the medium is the message’ , was for the 1960s.
The infrastructures – the mediums – of most concern are the models, like Black-Scholes, that at once define and drive financial markets and the computing power that implements the models. For as the late Prof. McLuhan continued:
…the personal and social consequences of any medium – that is, of any extension of ourselves – result from the new scale that is introduced into our affairs by each extension of ourselves, or by any new technology. [Emphasis added.]
Donald MacKenzie, a professor of Sociology at the University of Edinburgh, published that sentence in 2006, well before the financial crisis of 2008-09. In An Engine, Not a Camera: How Financial Models Shape Markets, he argued:
Firms and other economic actors do not choose their courses of action in isolation: they monitor each other, and make inferences about the uncertain situation they face by noting the success or failure of others’ strategies. When this leads to diversity – two firms selecting different strategies and coming to occupy different “niches” – a stable market structure can result. But if firms imitate, each choosing the same strategy, potentially disastrous “crowding” can occur. 
1998 rocked global finance far worse than 1987. This, Prof. MacKenzie argued, reflected the general adoption of modern finance theory models by investors and their incorporation into markets. The convergence of these dominant models and of the development of the computing power to drive them led to ‘crowding’ as on the tilting stern of the ‘Titanic’.
And without systemic change, he suggested in 2006, it would happen again and more violently yet. That change was within our power:
. . . the financial and other markets of high modernity are to a significant extent entities subject to deliberate design, and the details of their design are consequential. For example, the financial derivatives exchanges . . . were conscious creations, and U.S. stock markets have been thoroughly remodeled over the years…. 
…Markets, like technologies, are surely means – to be tinkered with, modified, redesigned, improved, and on occasion eliminated – not ends that can only be embraced or be rejected, They are not forces of nature, but human creations…. 
Just like the models that were in 2006 driving the financial markets toward Armageddon….
Last year’s ‘Flash Crash’ should have alerted investors and government to coming trouble in another sector of the financial markets where models and computing power have converged. It didn’t.
Prof. MacKenzie offers a lucid, dispassionate and detailed explanation of electronic trading. His description of how the ‘Flash Crash’ happened is better than I have seen anywhere.
Automated trading led to the ‘Flash Crash’. And it has moved us further from the required change. Dueling algorithms wielded without human intervention and sped by increased computing capacity have come to dominate markets that once saw men buying and selling face-to-face at stations on a trading floor.
The danger is that the electronic markets – think of several Wal-Mart type buildings stuffed with racks of servers – where the automated trading occurs are tightly interconnected while the algorithms are implemented in microseconds – millionths of a second.
The algorithms and their hosts are exceeding – have exceeded? – human capacity to influence them.
Prof. MacKenzie’s last two paragraphs, to which you should not skip, repeat his cautions of five years ago:
When thinking about automated trading, it’s easy to focus too narrowly, either pointing complacently to its undoubted benefits or invoking a sometimes exaggerated fear of out of control computers. Instead, we have to think about financial systems as a whole, desperately hard though that kind of thinking may be. The credit system that failed so spectacularly in 2007-8 is slowly recovering, but governments have not dealt with the systemic flaws that led to the crisis…. Share trading is another such system: it is less tightly interconnected in Europe than in the United States, but it is drifting in that direction here as well. There has been no full-blown stock-market crisis since October 1987: last May’s events [the Flash Crash] were not on that scale. But as yet we have done little to ensure that there won’t be another. [Footnote omitted.]
The inability of governments to regulate and financial institutions to restrain themselves leaves us with only the hope Prof. MacKenzie is wrong this time.
H/T: Jotham Kinder who pointed me to MacKenzie’s new article.
1. Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets  (Cambridge MA: MIT Press, 2008), p. 13. (Hereafter, ‘Engine’.)
2. Mark Federman, ‘What is the Meaning of the Medium is the Message?’ July 23, 2004, Retrieved May 17, 2011 from http://individual.utoronto.ca/markfederman/article_mediumisthemessage.htm. It seems to me that MacKenzie’s observation is a corollary to McLuhan’s general principle. MacKenzie does not cite or otherwise acknowledge McLuhan.
3. Engine, p. 272.
4. Engine, pp. 196-200. A superb description of a very complex crisis.
5. Engine, p. 274.
6. Engine, p. 275.