What happens when the two mix?

Chaos.

The amazing and unlikely story behind this dramatic transformation will be revealed in my new book, Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System. The book will hit bookstore shelves around the country on June 12. Already, there’s buzz about it. I know because people in the industry keep asking me (at times rather nervously) “when is your book coming out?”

It will make news. It will make people angry. It will incite controversy. And it will, no doubt, be attacked by the very people whose livelihoods depend on the status quo.

Which is ironic. That’s because, as I show in Dark Pools, these people–the new cyber-kings of the market–were the very same game changers who took down the previous privileged elite, the Nasdaq market makers, the New York Stock Exchange specialists, the powerful broker dealers at the giant banks, all the while championing a level playing field. The truth is, they’ve made the playing field anything but level.

The history of that transformation–and a chilling look at a possible future in which the human element of the market is forever erased–is told in the pages of Dark Pools. Stay tuned.

I also believe that the credit crisis was much bigger than toxic CDO (collateralized debt obligations). Banks were overlevered using overnight “repo” markets. Hedge funds were overlevered using faulty risk models. There was a popular delusion that the global economy was in a period of low volatility, which Ben Bernanke, in 2004, called the Great Moderation. Wall Street was collectively congratulating itself that, due to the great innovations of the quants, the entire system was more efficient.

As we all know, that was dead wrong.

I also did an interview at TheStreet.com today and another for Bloomberg Radio.

There have been some interesting developments in Washington in recent weeks that are related to issues I address in The Quants. The Obama administration, in consultation with former Federal Reserve Chairman Paul Volcker, is taking aim at proprietary trading, in which traders at Wall Street banks use firm capital to make side bets on the direction of the market. My book profiles two such prop desks, Process Driven Trading at Morgan Stanley, which used a statistical arbitrage strategy (betting on shifting relationships between stocks and other securities), and Saba, a Deutsche Bank prop desk that traded credit instruments such as credit default swaps. Both went through highly volatile periods during the credit crisis.

Many say the Volcker Plan will be ineffective, in part because prop trading only makes up about 5% or so of most firm’s profits (it’s a bit higher at Goldman Sachs). That misses the point. Prop trading was a big part of bank profits before the credit crisis hit, and was in many ways responsible for the huge gains banks were booking before the meltdown. Ironically, one of the key players in turning banks into (as I argue in the book) souped up, highly leveraged hedge funds was former Treasury Secretary – former Goldman Sachs CEO – Henry Paulson, whose book about the crisis came out a day before mine.

Here’s an excerpt from my book on page 200:

“Paulson himself had outlined the new paradigm in the bank’s 2005 annual report. ‘Another key trend is the increasing demand from clients for investment banks to combine capital and advice,’ he wrote. ‘In other words, investment banks are expected to commit more of their own capital when executing transactions…. Investment banks are increasingly using their own balance sheets to extend credit to clients, to assume market risk on their behalf and sometimes co-invest alongside them.’”

The phrase “co-invest alongside them” is an interesting choice of words. Goldman has been taking a great deal of heat for making bets that complex credit instruments tied to mortgages would lose value, to the detriment of clients of the bank who purchased similar instruments that did in fact lose value when the housing market fell apart.

My hope for this site is that it becomes a forum for thoughts about the role of quantitative finance in the markets, its risks and how it can be improved. I am by no means against quantitative finance in general. That would be futile, if not just plain stupid…like being against the air. Quants are a vital cog in today’s financial markets and have many extraordinary qualities. Yet their track record, sadly, is littered with wreckage.

Black Monday in October 1987. Long-Term Capital Management in 1998. And myriad blowups and near-disasters in between.

But those events pale beside the devastation of the last few years. Indeed, the pain has been so vast and so widespread that pinning blame on any single group may seem pointless. The Federal Reserve, which left rates too low for too long. Overextended homeowners. Fannie Mae. The Chinese…. The list of those accused is nearly endless.

Yet I believe that much responsibility should be borne by those who crafted the extraordinarily complex system that has become our modern-day financial marketplace, a world of mind-bending derivatives, computers linked around the world shifting billions in the blink of an eye, a theory about market efficiency that is blind to bubbles: the quants.

Securitization. The carry trade. Lightning-fast trading algorithms. Mind-boggling leverage. The quants for years claimed to have created a financial architecture that is more efficient, more robust than any that had been seen in history. And yet today, after a financial tsunami, the architects sit amid the ruins and place the blame elsewhere. They blame the tsunami. I blame the architects.

Absolutely, blame is to be shared. But unless we think carefully about the true causes of this most recent meltdown in the heart of our financial capital, Wall Street, we are surely doomed to repeat it.