The New York Attorney General’s lawsuit against Barclays’ dark pool is yet another example of banks’ increasing resemblance to asbestos manufacturers, but it also reflects an uncomfortable truth: Whether through “fast trading,” through the new area of “crypto-currencies” or through the increasing frailty of bank and corporate security systems, technology is transforming previously well understood markets into insider-dominated scams. The implications for the future of a free economy are dire indeed.
In a classic free market, buyers armed with a substantial amount of mostly accurate information about a security’s prospects compete with sellers armed with similar information, and an open auction decides the price at which the security is traded. Even in the days of “gentlemanly capitalism” this was never quite the way the markets worked in practice. London’s jobbers and New York’s specialists were often aware of large orders from institutions, and were able to manipulate their books ahead of those orders so as to profit from them. This made jobbing and specialist activity nice juicy businesses, blue-collar fountains of profitability in a world where most of the big money had been educated at Eton or Yale.
Initially, the arrival of computerized trading seemed likely to increase liquidity in the world’s stock markets. Certainly that’s how the new technique was presented to investors. We were told that the additional volume generated by computers would allow price quotes to be narrower, and ensure that buyers were present even in difficult market times.
Needless to say, this has not entirely happened in practice. For one thing, the standard rule that all trading had to go through the exchange was relaxed, with new “electronic exchanges” getting their share of the business. Though theoretically bids and offers on the new exchanges were duplicated on traditional exchanges, in practice there were too many ways for insiders to sneak new bids in against trades on a distant exchange..
What’s more, “dark pools” grew up, in which trades were matched without ever being shown to third parties. These dated back before true electronic trading, the first having been established as far back as 1971 to allow institutional orders to be matched inside investment bank dealing rooms, with the exchange being informed only afterward. Needless to say, once the principle of all orders being matched in a single arena had been abandoned, the potential for shenanigans was more or less infinite. The eventual denouement was caught by Michael Lewis with his customary elegance in his recent “Flash Boys” earlier this year.
Thus share trading is no longer a free market. Instead, as Lewis documented, orders are able to jump ahead of other orders, or be retracted if an order appears that might match them unprofitably for the fast trader.
Share trading is not however the only area in which markets have been degraded by technology. The fashionable new “crypto-currencies” such as Bitcoin are also not what they seem. They are created by solving electronic “problems” that get progressively more difficult as the supply of currency dries up. They can be stored in virtual wallets and traded through virtual banks, one of which Mt. Gox has already failed. That has caused much market uncertainty as the “transparent” process by which Mt. Gox’s deposits were assessed turned out not to be transparent at all.
Bitcoin, at least has shown an admirable tendency for the price to rise, albeit with massive unexplained fluctuations. However its success has brought out a mass of competitor crypto-currencies, which share Bitcoin’s characteristics, albeit with different creation algorithms, but alas without Bitcoin’s gratifying tendency to increase in value.
Some months ago I compared Bitcoin to the Mississippi Scheme of 1718-20, under which the Scottish financier John Law took over the French circulating medium and then bankrupted the country. It resembles Law’s scheme in one important respect: it is fiat money, just as much so as money created by the Fed or the Bank of England. If you feel more confident devoting your wealth to the goodwill of nerds in basements than to the world’s monetary authorities, it may be a better alternative than the dollar or the euro. Personally my distrust for central bankers is only exceeded by my distrust for nerds, so I will remain in conventional money (or in investments such as gold mines that may benefit from conventional money’s collapse). However I recognize that tastes may differ and that Millennials with a full portfolio of i-products and multiple accounts on Facebook, Twitter and their derivatives may find Bitcoin and its competitors an irresistible store of value.
Apart from their unsatisfactory nature as stores of value, crypto-currencies also damage the market system in that they can be hacked. The disappearance of a massive hoard of Bitcoin in the Mt. Gox debacle has only not been matched in other crypto-currencies because their value so far is not worth stealing. There is nothing natural or market-set about crypto-currencies’ value’; it depends on the algorithms governing their creation and the whims of fashion between the competing currencies. While each crypto-currency may have an algorithmically defined final volume, restricting its circulation and boosting its value, experience has shown that the barriers to entry into the crypto-currency world are minuscule, so a period of success for Bitcoin will just attract a blizzard of further competitors. In this respect Bitcoin is in the same position as the South Sea Company, a pioneer whose success brought a myriad of imitators, including the notorious “undertaking of great advantage, but nobody to know what it is.”
Needless to say, gold suffers from none of the imperfections of crypto-currencies. It remains free from interference by dozy politically-oriented monetary officials as well as by greedy obfuscating nerds and hackers. In this respect at least, old-tech wins by a country mile.
A third and even more important way in which technology is destroying the market comes from the increasingly worrying world of cyber-weapons. The Russian malware “Energetic Bear,” revealed last week, infected the computer systems of more than 1,000 major corporations worldwide. You only have to consider the mayhem inflicted upon the U.S. retailer Target last winter, when 40 million credit card details were stolen from its systems, to realize the potential for disaster in these activities. What’s more, preventing criminals from profiting massively by such fraud is not enough; there are hacker groups in both Russia and China, with murky connections to those malefactor states, whose objective is not simply profit but destruction. The dangers of malware appear to be getting worse, and it must be likely that eventually, a malefactor will succeed in corrupting a major portion of the world’s information systems. At that point, recovering Big Data will become a Very Big Problem.
Given technology’s damage to free markets in stocks, currencies and commerce generally, it is tempting to revert to the attitude of Ned Ludd, who smashed two stocking frames in protest against mechanization, but apparently in 1779, not at the time of the Luddite riots of 1812. By the latter date he was already a legend, not a reality, his story revived by the Nottingham Review in December 1811.
Ludd’s original protest may have been inspired by nothing more than his being whipped for idleness, but his spirit has infected anti-technological feeling ever since. At the time of his protest, and of the 1812 protests inspired by his memory, the economically rational decried his activity, claiming correctly that even though some livelihoods would be destroyed by new machinery, it would make the process of production so much more efficient that the overall gain in welfare would be considerable, while those displaced could improve their lot by retraining on the new machinery.
A large number of eggs have been broken in the last 200 years in making this industrial omelette – one thinks for example of the miserable cottage-industry hand weavers of “Wodgate” in Benjamin Disraeli’s 1845 novel “Sybil” – but Ludd has nevertheless continued to seem misguided.. Each new industrial advance has enabled the process of production or service provision to be carried out more efficiently and with the use of less labor, thus increasing human welfare overall.
Nevertheless, at this point, when confronted by the damage to open markets caused by computerized trading, crypto-currencies and the ever-increasing threat from the global hacker community, Ludd’s view may have greater salience. If technology destroys the delicate mechanisms by which our complex economy is held together and the economic system is optimized, is it increasing overall welfare or destroying it? In an extreme case, if it were no longer possible to trade securities fairly, no longer possible to find a reliable store of monetary value, and no longer possible to pay for transactions without bearing a major risk of being looted, then a market economy would become impossible to operate and our welfare would degenerate to a pre-industrial, subsistence level.
Ned, baby, we no doubt prosecuted you in 1779 and we certainly hanged several of your followers in 1812. For 200 years since then, we have used your approach to technological change as an example of all that is most irrationally opposed to progress and human betterment. Yet in today’s world, we are less sure. Can it be that, far from regarding you as a misguided, even feeble-minded agitator, we should instead regard you as a visionary of the damage technology can eventually bring? Maybe you, not Adam Smith, are the eighteenth century economic prophet our unfortunate descendants, impoverished by technology carried too far, will come to revere!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)