Smart Money, Dumb Contracts: How Fat Cats Can Eat Blind Mice
In the age of high-frequency trading, the time honored equilibrium in the feedback loop of pursuit, capture and escape is becoming increasingly distorted.
Regulation is a game of cat and mouse. In the age of high-frequency trading, the time honored equilibrium in the feedback loop of pursuit, capture and escape is becoming increasingly distorted.
Long and arduous is the process by which financial regulation is conceived and implemented, taking on the order of months to fully realize.
This is a classical procedure which traces its roots back to an age where commodities crossed the Atlantic on schooners and the code of conduct was scrawled out longhand with quill pens. In those days of yore, if legislation contained a failure or loophole it could be exploited only so many times before it was possible to stem the breach.
Our digital age is described by, among other things, adaptive machine learning processes that are capable of executing transactions in fractions of a second. As such, while the time horizon during which legislative oversights might remain vulnerable has generally remained constant, our ability to exploit them has increased by a degree previously unimaginable.
Fat cats vs. blind mice
The Flash Crash of 2010 was a trillion-dollar stock market collapse that started and ended during a period of approximately 36 minutes.
In his recent book ‘Our Revolution,’ Bernie Sanders prides himself on a filibuster which lasted eight hours. That means that while Bernie was so eloquently holding forth on the floor of the United States Senate, the American economy could have experienced more than 13 consecutive trillion-dollar stock market crashes.
It would seem that there is a fundamental discrepancy between the way our modern financial markets function and the way they are policed. The financial industry is fiercely competitive and encourages a Darwinian impetus to improvement. The legislative industry labors under no such compunctions. In the cat and mouse struggle previously alluded to, it seems the so-called “fat cats” have grown considerably more fleet than the “blind mice” of justice.
The investigations of the Flash Crash were said to be prolonged due to the fact that regulators figuratively used the equivalent of bicycles in an effort to apprehend speeding Ferraris. In essence, regulations can be thought of as a “contract.”
Machine learning algorithms can grow and adapt in seconds or less, while regulation takes on the order of months or more. It would seem that were regulation to keep up it would need to be more fluid, more adaptable.
How could this be possible? Perhaps what is called for is a smart contract-based regulatory environment that can adapt in accordance with a predetermined set of parameters, to the behaviors of market participants.
FCA tech sprint
It’s an anomalous state of affairs that in the native land of Sir Jonathan Ive, Charles Babbage, Alan Turing, Vice Admiral Horatio Nelson, Field Marshal Arthur Wellesley and the Spice Girls that there are so precious few world renowned tech companies (should we count DeepMind?).
In fact, one of the only vibrant and globally competitive industries that remain in Great Britain is financial services. Accordingly, the Bank of England and the rest of the city are quite keen on keeping abreast of the emerging trends in so-called “FinTech.”
It stands to reason then that the Financial Conduct Authority recently organized their first Tech Sprint (viz. Hackathon), inviting innovators from around the world to come to Cambridge and demo the latest advances in the field.
Flash Crash can repeat itself
Of the organizations in attendance ‘eccenca GmbH’ of Leipzig unanimously blew away those in attendance with the presentation of a framework pioneering a new architecture for logic based regulation.
At a high level, this equates to describing regulation in machine-readable computer code, a necessary prerequisite to smart contract based regulation. We find ourselves today in the undesirable situation of attempting to govern digital-age technology with depression-era legislation.
Five years after the Flash Crash, traders can still manipulate and impact markets using automated trade systems that have only increased in sophistication.
The logic based corporate governance model of eccenca and other similar initiatives are leading the charge in achieving some semblance of parity in the struggle to maintain regularity in the global financial system.
Ripped from the headlines
One year ago the Commodity Futures Trading Commission (CFTC) of the United States established a regime of regulatory requirements circumscribing the requisite margin on trades between swap dealers and other firms that weren’t routed through clearinghouses.
This policy as released at the time contained a glaring loophole which essentially constituted carte blanche for banks to shift the targeted swaps business overseas with impunity. It was five long months before that hole was identified and corrective measures were taken.
In the interim how much strain was put on the financial system? How much tax revenue was forfeit? How much additional risk was borne by the world economy?
Times are changing
For the majority of human civilization, the lives of people in their local communities remained substantially unchanged, with respect to technology or culture, across the decades.
If your father was born in a small shtetl with no running water or electricity it was likely that you would live out the course of your own life in the same way, in the same place. It was likely that your children, your children’s children, and so on, would do the same. This epoch is over.
My own life began in the year that hallmarked the modern age, with Tim Berners-Lee’s invention of the World Wide Web and the ceremonious dismemberment of the Berlin Wall (“Antifaschistischer Schutzwall”).
All of us alive today have born witness to the dizzying pace of technological and social change that describes our times. The tempo of this change is ever hastening, like the power ballad "Freebird" by the American rock band Lynyrd Skynyrd. This epoch has just begun.
The time for ideas and institutions of the past epoch is quickly running out. The time for modernization is now. Change is the only constant.
From smart contracts to smart regulations we can rest assured that these shifting dynamics will present sizable opportunities for those who are prepared to seize them.