Lambda the Ultimate

Only if all of the instruments were public. While the contracts on the underlying assets would be public information (from the exchange that handled them), there is no reason to assume that people would disclose the connections between those contracts in the form of these instruments. In particular many traders would not want to disclose their trading strategy.

Analysing the state of the overall market would be an interesting problem if all trades / contracts were expressed as programs. But the first question would be what to analyse? The obvious desire would be to calculate some level of "stability" for the market, but this would be an intrinsically hard problem. Any solution would depend in some parts on analysing the numerical stability of the various algorithms at work in the market place, and in other parts on computing the equilibrium of games between the traders.

It would be interesting to know what other analyses could be attempted. After the recent financial crisis it is intriguing to wonder if we could have analysed "Who has lost their shirt after event X, or in circumstance Y?" A bigger question for the regulators would have been which institutions X & Y have correlations between their assets / positions that depend upon each other?

You are right, of course. There are many additional complications. My basic point is that auditing is hard, and automatic auditing is a great improvement. I am not suggesting that all the data be public (though some of the important data is public as it is), but rather that government regulators can gain access to private data (if the law so demands), and that if this data is specified in languages that allow automatic auditing, so much the better.

There is an interesting parallel between specifying financial transactions as programs, and expressing each action that a business takes as a program in some language. I certainly agree that company reports would have a lot more meaning to regulators if they were in an executable format. Instead they manage to hide what they are up to in 900 pages of natural language. I have a vague memory of a story here on such a language, but I can't remember enough search terms to make Google agree with me.

Are you thinking of XBRL?

Perhaps you're referring to Nick Szabo's contract language, or my follow-up on Luke Palmer's "Dana" effort.

Yes, this sounds more likley.

Actually I was thinking of XBRL, but Nick's language is much more interesting and I missed the link to his paper first time round :)

If all instruments and contracts are specified in a standardized executable form that regulators can access, static analysis is not the only way to search for possible cracks in the system. In the short term running simulations is probably a more tractable avenue. Financial firms already seem to be doing this in routine basis (see what we write in section 1.3); all that is needed for more effective regulation could be standardization, transparency, and analysis resources.

I was baiting you with the static analysis suggestion...

But seriously, do you think what you suggest in your last sentence is practical?

I'm ashamed to admit that the bait worked amazingly well!

Regarding the practicality of the approach I suggested, I very much doubt it can be put in place; no global system similar in scale and complexity to the proposed one has ever been put into work. Currently, organizations that work on a global scale, say the World Health Organization or the European Aviation Safety Agency, work with aggregate data from countries or industries or with specific incidents. However, this approach isn't suitable for regulating financial markets at a global scale, because, as we've recently witnessed, these can operate chaotically: rising mortgage defaults in Denver can bankrupt banks in Iceland.

Proposing a global system that could monitor this complexity is an interesting academic exercise. However, its realization will be difficult and its efficacy uncertain: remember that the sophisticated risk management systems of many financial institutions failed to protect them from collapse. One could counter this argument by saying that a complete global view could take into account risks that the systems of individual institutions couldn't know. Still, the currently suggested self-stabilizing measures, like dynamically adjusted capital requirements, seem a much more practical way forward.