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Financial

singularity and the death of capital markets



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Financial singularity is considered as far less dangerous than technological
singularity because artificial intelligence, when applied to finance, doesnt directly
threat our physical integrity.
Harmless.
Is it ?

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When the brightest minds in artificial intelligence and robotics warn us about
the threat offensive autonomous weapons represent to humanity, we realize that
technological singularity could be imminent.
High-profile influencers and researchers with the names of Stephen Hawking,
Steve Wozniak and Elon Musk tell us that the global AI (artificial intelligence)
arms race may start soon, or, worse, that it has already started. They tell us that
we, humans and the people who lead us, have the responsibility to stop this
before it is too late.

Critics of technological singularity argue however that such warning signs are
unnecessary because we are at the embryonic stage of military artificial
intelligence. The basis for their argumentation is that similar warnings were
issued 20 years ago over cloning, perceived as a major threat to the
sustainability and the evolution of our human race. Unnecessary warnings
because no real threat has arisen from cloning experiments. Out of context, this
may be true. But we are in 2015 and technological breakthroughs supported by
shorter discovery and development cycles allow for technologies to progress
much faster than 20 years ago. And to have deeper impacts on our lives.
Unarguably James Camerons 1984 Terminator was science fiction at the time it
opened in theaters and remained science fiction for 30 years. Now to become
realistic and possible. AI-powered human-like robots could see life soon and we
can express doubts about the willingness and ability of our leaders to stop this.
Musk, Hawking, Wozniak. Against Moores law and corollaries, who stands a
chance ? Things are moving really fast. People leading change and disrupting
industries today are not the researchers experimenting cloning on sheep in the
90s. They are entrepreneurs with unprecedented financial reach. Rogue nations
may not lead the AI military race or even trigger the need for this. Billionaires
running the next unicorns or decacorns may do.

Whether mankind will stand against offensive autonomous weapons before
technological singularity and will stop further research in this space or not will
certainly be at the center or many debates. And we are just witnesses.

In the world of finance, the topic is overlooked and the debate quasi-inexistent.
Financial singularity is considered as far less dangerous than technological
singularity because economic weapons, if they exist, dont directly threat our

physical integrity. The automation of banking processes, robo investing software,


AI-based black box hedge funds, crypto-currencies and digital banks are
considered harmless. That we think they are. But financial singularity may do
more harm to our societies than offensive autonomous weapons, only because
the latter would be intelligent enough to know when peace is the best solution
for all. To leave a role for humans. Financial singularity, on the contrary, may
simply lead to removing the element that makes financial markets inefficient :
men.

The perceived mirage of financial singularity

Several economists including Robert Shiller talk about the mirage of financial
singularity; the impossibility for it to happen because of the major impact human
behavior has on the financial markets. But Shiller only touches the surface of
what total disruption of our financial markets could be. And to some extent this
is an insult to the potential of AI. Full power in AI does not lie in analyzing core
economic and market data, it does not lie in unbiased investing or in the speed at
which algorithms can gather and process information. It does not even lie in
learning how men trade and how participants behave, or in accounting for
irrational patterns. By learning, understanding, anticipating and eventually
mastering concepts such as greed & fear, panic selling, moral hazard and other
behaviors, algorithm-based advisors will quickly be able to neglect human
intervention. What we, investors, do today to the markets will just be noise and
AI systems will take over.

The Chinese stock market is under pressure. Some say it is a healthy correction.
Economists, financial analysts, fund managers have warned us about the heat in
the market and the bubble, for months or years. Would AI investment vehicles
have allowed to cold down the market before the recent sell-off ? Yes, but only if
AI-induced flows had surpassed traditional flows. Only if Chinese and overseas
investors had agreed to or wanted to consider what AI technology was telling
them. So the only answer is no. Not in 2015.
In the airplane, the pilot is a problem. And the right the pilot has to disconnect
the autopilot is unfair. Why cant the autopilot have the right to override a pilots
action. Germanwings. The computer knows. Humans dont and influence systems
the wrong way. We dont want to allow robos to drive the markets, even if they
are more able to do this than us.

So Shiller is right. Financial singularity is a myth because men influence the
market. Because markets are not efficient and news, flows and behaviors have a
deeper influence on stock prices than rational factors could ever have. Missing or
exceeding analyst expectations drive prices more than the reported financial
data themselves.

But financial singularity goes well beyond the idea that AI could meet human
behaviors. It goes well beyond automation. Most of the processes in retail
banking can be automated, since humans are only adding risks for errors instead
of value. No AI is even needed to create retail digital banks. Basic scripts can
mimic most, if not all, operations. And do better.

In the investment world, robo advisors are gaining in popularity because they
demonstrate that the value added by most investment managers to their clients
is quasi-inexistent. Even of greater importance, they offer solutions at a fraction
of the cost. Low cost beta investing and simplified asset allocation for the masses
are attracting large family offices, UNHWI and institutional investors. But in this
field, again, we are more talking about automation, fast processing of data and
rational investing rather than AI-investing. Translating one investor profile into
an asset allocation map and investable products, mainly ETFs, is no rocket
science. Portfolio optimization not even more. And robo advisors dont even
come close to override investor behavior flaws.

While this is the situation today with Shillers case being valid, I argue that
tomorrows situation may significantly differ. That financial singularity is not
what some anticipate it to be. If we agree that progresses in AI R&D will continue
to accelerate, and accelerate even exponentially, both in development cycles and
capabilities, then we should revise our very own understanding of financial
singularity. Way beyond robos understanding participants investment and
trading behaviors.
Algorithms can easily identify behavioral patterns when they try to anticipate
market movements driven by activities built on irrational grounds. We now have
access to AI systems that can trade using fundamental analysis, that can include
and analyze flows, analyst opinions, irrational behaviors and all sorts of patterns.
Some systems can and will self-improve to reach a first point of non-return, that
shall triggers many alarms, increase market risks and volatility. By learning how
markets move and how irrational behaviors trigger flows greater than the
fundamental ones, machine investing will align with human investors. To even
precede and trigger worse behaviors. Schillers point is that in case of a massive
sell-off, irrationally-triggered flows will dominate, increasing the downside even
if machine advisors would recommend buying. Automated systems will be able
to anticipate such market movements, knowing ahead of time that human will
sell. Machines will trigger the correction. Anticipation and prediction will be
based on the analysis of unstructured data coming from all sources, building
predictive patterns indicating that market participants are on the verge of
selling. The most sophisticated systems will analyze market data, trading flows,
research, internet searches, social media, specialized sites, but also combine the
analysis with financial institutions own databases and systems. Adding an extra
layer of information, such as geolocalisation, ATM activities, CCTV, satellite
images, machines will know everything before market participants act. Human
will simply do what they intended to do, but not just by following a trend, but by
following AI trading activities.
This first phase will allow an alignment and an overlap of AI-induced flows and
human ones. Algorithms will rationally include humans irrational behaviors to
improve their predictive power.

Point of no return

Because then, trading flows generated by AI systems will be big enough to
influence the markets and surpass human activity, not just influencing it.

Schillers case is losing grip. And financial singularity is still nowhere near. But
the steps towards it are set.

When AI flows coincide with human trades, AI-based systems will have achieved
two things: first, they will be able to set a fair price on financial instruments and
assets, using multiple factors and degrees of optimization; second, they will have
learnt the keys to the Keynesian beauty contest, mimicking human behaviors and
anticipating irrational flows that can and do move markets.
After this phase of high volatility, when accentuated and leveraged irrational
behaviors send markets to Heaven and Hell, will come a phase of managed
markets. One could eventually call the market genuinely efficient. Robo-advisors,
AI-managed funds, rebalancing tools, portfolio management systems will all
apply these unprecedented capabilities to not only predict markets using deep
understanding of human behavior, but will start directing the market to fairer
valuations. The golden age of efficient markets. A haven for fundamentalists and
adepts of fair pricing. No financial or asset bubbles. Low volatility. No market
manipulation. No surprise.

Boring. Boring, because investors can benefit from inefficiencies, some asset
managers (in fact, very few in a consistent manner) are even generating excess
returns, alpha over market performance, when capturing opportunities created
by market moves, price adjustments and mispricing (read Sean Parks
(In)efficient markets on this topic).
AI-driven efficient markets will assure fair pricing of financial assets. Equities,
bonds, currencies. But also real assets, private equity holdings or any security
that can now be marketed-to-market or evaluated and priced using advanced
algorithms that include all rational and irrational models. When humans rely of
DCF, multiples of EBITDA, comparable companies or very subjective models to
value private holdings during funding rounds, AI will include all of them as well
as new models, not yet available or used by us in 2015. Models we may not even
understand or be able to approach. With efficient markets will also come a full
set of predictive money management solutions. If rationally-priced assets is now
the norm and humans cant influence the markets, portfolio management will
become obsolete. Asset allocation will be an automated process. With AI-
managed markets will also come the end of financial professionals. Fully
automated processes will replace traders and brokers. Fund managers, with the
impossibility of generating alpha, will disappear, replaced by ETFs at first, then
by new forms of pooled investment vehicles. Ironically, the whole concept of
managing money thru investments will be brought down to a very simplified
process, but a process managed by over-fitted black boxes. Up to a point that it
will become a self-infused and always improving process, non-understandable
by humans. 5% per annum ? Sure. 10% ? Sure. Independently of risk profiles.
Risk will become totally manageable. Irrelevant concept.

AI algorithms will be able to automatically match needs with a virtual demand
and with capital. Algorithm will automatically implement the right capital
structure for a company. The right price for new stocks, the right level of debt,
the best yield. A new issue will automatically be allocated to the investors who
should buy it. No more road shows or pitchbooks. No more research and analysis

because humans wont have time to publish or read them. Stock analysts will
have a second life as historians of the markets.
Asset allocation will then disappear, with AI merging asset classes into new
concepts. Capital markets will disappear. Bankers will be gone.
The very concept of stock exchange (or any exchange) would become irrelevant,
with AI allocating resources to needs directly.

Pension funds will be gone. From a salary, money (assuming this concept
persists) will automatically be allocated to pooled solutions to manage future
needs and generate returns. Even crypto-currencies will be short-lived. New
solutions will emerge allowing humans to get access to goods, according to a
conceptualized financial health. Get the vehicle you need according to what you
can afford and get it financed the best way.

Capitalism 3.0 with no capital

Financial singularity is about the dematerialization of our banking system and
our capital markets. It is about AI redesigning existing processes, developing and
implementing new ways of building and managing wealth, in a less Keynesian
way. Capitalism 3.0 with no capital.

Financial singularity can happen, simply because at some point AI will surpass
the first barrier, identified by Schiller as a hard obstacle to allow this to happen.
We, human, cant and wont stop this.

What we need to do it to develop an approach towards this. To already design
master frameworks for the banks and the markets of the future, like for directing
ivy wines on a wall, we should direct AI in the development of future
technological solutions. Think like AI systems. Become AI.

Crypto-currencies, blockchains, robo-advisors, they are just small bricks in a
great wall that is being built. Banks and market participants must understand
this and have to invent the models of tomorrow or at least anticipate them.
Learn and master them.
They have to become proactive and far less reactive, and focus on the bigger
picture, 2025+, not on the themes of yesterday or today.
Quite a challenge.


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August 2015

Richard Joye is founding partner at KCHK, a financial advisory boutique
headquartered in Hong Kong with global network. Richard and team focus on
disruptive technologies.

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