The implications of complexity in financial markets are more pointed than for most other industries: In the financial markets, some participants have a self- interest in gaming the system. Traders do not act as uninvolved parties. They are ready to take advantage of increased complexity in the products and organizations to serve their own bottom line, making it all the more likely that the unanticipated crisis will appear. Complexity helps the malfeasant.
Complexity can be managed if there is time to observe and investigate and to take steps to intervene in a process before it runs out of control.
The greatest dangers arise when there is both interactive complexity and a tightly coupled system that does not provide the time to intervene. A tightly coupled system must be run and managed by the book. …a tightly coupled system provides no slack, in terms of either the time between steps, the ability to make on the fly alterations, or the opportunity to intervene. The by-the-book mode of operation that is required with tightly coupled systems is precisely the way get into trouble with interactively complex systems. Interactively complex systems require a decentralized approach that provides for creativity at the operator level in dealing with unanticipated failures.
The problem with adding safety features to systems that are complex and tightly coupled- the very systems that by nature have the greatest risk of catastrophic failure- is that they can actually increase the likelihood of these failures because they contribute to the source of the problem: interactive complexity.
From A Demon of Our Own Design by Richard Bookstaber
HKO comments: By writing regulations addressing the last problem we add complexity which causes the next problem. This is further complicated by the social engineering inherent in political tinkering. An alternative is to seek to expand the number of players and make it easier for newer players to enter the field. Unfortunately the tendency to increase regulations makes the barrier to entry ever greater, and increases the likelihood of another round of “too big to fail”.
Regulations should seek to both increase transparency and decrease complexity. Much of the complexity that polluted our financial system was simply a cover for excess leverage- the foodstuff of most financial collapses. Some overly complex instruments should simply be banned.