Finance: The Fork In The Road

Includes: ICE, NDAQ
by: Kurt Dew


Friday, the IEX became an exchange, and DAO was hacked.

These two events changed the financial world.

Exchanges will never be the same.

And cryptocurrencies reconsider assumptions about governance.

From now on, it can never be the same as before

'Cause the place I'm from doesn't exist anymore.

- Immortal Technique

This past week marked the first time I can recall the financial news being dominated by two FinTech phenomena that, five years ago, most people were unaware existed. And for FinTech, it marked the fork in the road.

One day, we will remember last week's two developments - signs pointing toward a new financial system we can barely imagine today; and away from our present broken-down, corruption-ridden system that rewards accomplishments of the past at the expense of efficiency tomorrow.

There were two developments: IEX's approval for exchange designation by the SEC; and a hack of DAO, a crowdfunding experiment based on the cryptocurrency, ethereum, that involved loss of control of about a third of DAO's assets.

IEX: The SEC's decision to grant the dark pool, IEX, exchange designation was a victory in the campaign for a revolution in stock market trading - a struggle that has just begun.

DAO: The hacking of the FinTech entity, DAO, will be infinitely more difficult to describe than the IEX victory. But in the same way that the IEX approval was a victory for FinTech, the DAO hack was a defeat. The essential promise of the cryptocurrencies is that they cannot be hacked. When a project like DAO, resident on the cryptocurrency, ethereum, gets hacked, it's a setback, although ethereum itself was not hacked.

Both events are important. They are the symbols of nascent forces driving our financial system to become more efficient.

Don't underestimate the significance of the bigger picture. These two events are skirmishes in a greater war. The endless war between the forces of privilege born of success during the last crusade to revolutionize finance, and the revolution of the current crusade.

This is the greater struggle. The stock exchange campaign and the cryptocurrency campaign are subplots in the greater war between the old dusty dreary forces of reaction - hidden in established financial institutions and within the bank regulatory and policy structure. Meanwhile, the new forces for change are to be found today fighting their way out of the old banking establishments - like the youthful band at IEX, or in the IT community - scattered around the globe in universities, startups, and in some cases newly recruited by the old banking system.

Bankers of my generation each have a choice to make. We can take the existing banking structures and the rest of the blueprints of our old financial system - the exchanges, the clearing, and settlement firms, the regulators, the data providers - as edifices that represent the triumph of our struggles to defeat the risks and dangers we faced over the past decades, and indoctrinate our intellectual offspring to do the same.

Or we can face the truth - that those struggles go on, and the tools we created to overcome the dangers of the marketplace are like metal pipes. They were the best we could do, but they need to be trashed and replaced.

When we consider the prospects of our individual financial institutions each quarter, we make that choice anew. If we think a bank's future depends mainly on monetary policy during the next six months, or on how the bank will meet the regulator's latest CCAR or "living will" test, we have given up on this bank. How can those things really matter for the bank's future success? They exist only to limit banking opportunities. But in the case of many of the current crop of financial institutions, monetary and regulatory policy summarizes the bankruptcy of their current planning, so focusing upon it is an entirely appropriate decision.

I have written articles about what some of my readers call "financial plumbing" - the issues of FinTech. Of course, finance is plumbing. Finance is the word for the pipes that direct the flow of resources from savers to projects and the companies that sponsor them.

I focus somewhat upon the current out-of-date broken-down plumbing of today's marketplace - the banks, but more than most analysts upon the pipes that will make the financial system work better in the future. More than anything, this focus results from what I learned when I was a financial plumber myself, that the pipes are more important than most investors realize. And our financial pipes need quite a lot of help.

Indeed, our financial system has gotten so irrational and complex that investors forget it is only meant to be the pipes - pipes that carry people's savings to its ultimate use. We pay too much attention to the plumbers - so much more than their true value that we have lost track of the fact that they are only plumbers.

And FinTech is about putting an end to that, eventually. It will take a long time.

The IEX exchange designation. The first tech news of the week concerned the technology of trade execution on our major stock exchanges. IEX introduces new trading technology spawned by a different philosophy than the other major exchanges. IEX is not maximizing the revenue that it can extract from high frequency traders (HFTs) for providing the function of an exchange, as the other exchanges [The New York Stock Exchange (NYSE) a subsidiary of ICE (NYSE:ICE), Nasdaq (NASDAQ:NDAQ), and the BATS exchanges do now.

IEX received exchange designation from the SEC Friday, June 17th. I am a supporter of the thrust of IEX's efforts, which focus on providing a trading venue that is less vulnerable to the market manipulation of HFTs.

I am, however, agnostic about the future of each of the exchanges, including IEX. The struggle between IEX and the other exchanges has been portrayed, to date, as a morality play. IEX represents fair treatment of customers that pay the other exchanges to get exchange fees early. IEX has introduced the "speed bump," a way of slowing down orders coming into the IEX execution engine. The purpose of the speed bump is to assure that HFTs do not have an opportunity to modify their orders after they "see" the incoming orders of other traders on IEX. The result is that the "book" of buy and sell orders that the average trader "sees" when she places an order cannot be changed to exploit her order as it arrives. In other words, "What you see on IEX is what you get."

This is not true on other exchanges, where HFT traders have the ability to change the market spread after a "hidden peg" order - when a firm's hidden buy order is placed at the midpoint of the current bid-ask spread - is placed; the HFT hits the hidden bid while lifting its own bid, then buys back its resulting position at a profit at the new lower market price.

As I intend to explain in later posts, the speed advantages provided to the HFTs by the other exchanges is part of a much larger issue of providing more efficient exchange trading services to the trading public. Brad Katsuyama, the CEO of IEX, shows that he is aware of the much larger issues out there, but I see no signs yet that IEX has the will to take them on.

The DAO Hack. The second big story of the weekend involved a second important FinTech initiative, cryptocurrencies.

This second story was less positive for the new world of FinTech. The crowd funding "entity," DAO, was hacked. DAO is part of the world of cryptocurrency technology, which I call Bitcoin/blockchain/distributed ledgers (BBDL). This entire subject is one that the entire financial community, including the readers of SA, need to be convinced is fundamental to the future of finance. Cryptocurrency technology will, once it gets its act together, replace most of the old banking technology.

The effect on banking income and cost will be enormous. The usual estimates that some banks have released put the loss in revenue at 25% of total revenues. That doesn't come close. The savings may mean we once forget that we needed to devote substantial resources to transactions. There may not be any more banks. There may not be any more accountants.

Making change (pun intended). Let me take just one example that hit me between the eyes as I was listening to a friend's anecdote about his recent visit to Turkey. My friend mentioned that merchants have trouble making correct change when he used Turkish currency. The same is true elsewhere in the world, as it is here in Mexico. This is reminiscent of a bit that used to appear on Saturday Night Live. In these SNL skits, a banker trumpets her ability to make change - no matter what denomination the customer might need. Supposedly ridiculous. A couple things about that skit:

  1. Don't ask your branch for a $100 bill in change. They don't usually carry them. So US merchants can't make change either.
  2. In the modern internet world, making change in any denomination is a more expensive proposition from a bank's cost point of view than any number of services banks provide, but for which they charge much more. Why, for example, can't you buy dollars for pesos through your computer hookup to your bank, and pesos for dollars (at the same exchange rate)? In the internet world, the real cost to the bank of this transaction should be far less than the currently free service of going to your branch and getting quarters on laundry day.

In other words, the SNL skit is a parable about the outdated plumbing of the banking business. The entire structure of banking services' cost and availability is out of date.

Why? The reason is that bankers do not want to lose their out-of-date inflated compensation for once-challenging activities like FX trading, that no longer should be challenging. In less flattering terms: the banks are corruptly maintaining their old, now-exorbitant compensation.

Without cryptocurrencies, this old corrupt system will ultimately collapse. But cryptocurrencies are important because they promise a way of conducting transactions that completely eliminates the banking system. This promise is scary. And as I read comments on SA, I can see it is scary to people who routinely condemn the banks.

There are some natural human instincts involved. People fear change. While we routinely admire the agents of change such as the internet innovators, we find them intimidating. The very young are more comfortable with changes in telecommunications, not because they are brighter, but because they fear change less.

But humans fear change for a reason. Change is unpredictable. Hence dangerous. And the important revelation of the DAO hack is that the cryptocurrencies are still too dangerous to go mainstream. There is a fundamental unmet need for a moral structure within cryptocurrency's function. This is the most significant missing conversation in the discussion of the future of cryptocurrencies. And of course, this is harder than writing code. It will take decades, not months or years.

Cryptocurrency developers would like to avoid the issue. Even banks and bank regulators open to use of cryptocurrencies would like to avoid the issue. But this week's DAO hack brought it front and center. And DAO has only itself to blame, because they are in denial about the ethical issue they have created even now.

The DAO hack showed that the cryptocurrencies are not ready for prime time. There are two reasons:

  1. The cryptocurrencies are still too vulnerable to unexpected behavior of individual IT professionals. The DAO hack moved value in the amount of several million dollars in a way that was inconsistent with the plans of DAO's designers.
  2. The public needs to understand the function of a cryptocurrency. Then it needs to be convinced that it can control these cryptocurrencies - that is, is the worst that can happen to a user of cryptocurrency an acceptable thing? No cryptocurrencies will enter the mainstream until the answer is a qualified "yes." Then there must be a legal framework for deciding appropriate reactions to individual behavior that is not expected.

In this BBDL world, nothing ever is as it appears. One answer to the question "What is DAO?" is that it is simply computer code. It has no people in charge. It was written, in this version of the truth, to create an electronic "locus" of investment funds to be spent on future Ethereum technology. But if it is code, it has no objective except to execute instructions within the code.

The most important question in this FinTech space - yet I believe the most neglected question - is the ethical/societal implication of the apparently amoral decisions of the cryptocurrency "nerds."

The apostles of FinTech, from IEX's Brad Katsuyama to Vitalek Buterin, come off like tech whizzes, but they cannot avoid the philosophical underpinnings of their decisions. These people are as important to the moral landscape of the next generation of financial professionals as John Meriwether and Michael Milken were to theirs. And it would benefit both Katsuyama and Buterin to inform themselves about the careers of Meriwether and Milken - the nerds of my generation. These two men were well-intentioned, brilliant innovators that were ultimately villainized. I wish on Katsuyama and Buterin fewer regrets than the nerds of my generation.

What fascinates me most about financial IT is the disparity between its image and its reality.

Wikipedia defines a nerd as "indicating a person that is overly intellectual, obsessive, or lacking social skills. Such a person may spend inordinate amounts of time on unpopular, obscure, or non-mainstream activities, which are generally either highly technical or relating to topics of fiction or fantasy, to the exclusion of more mainstream activities."

The new apostles of financial change cannot be nerds. They must confront, address, and defend the moral implications of their technology.

This week Brad Katsuyama showed he was aware of this responsibility he bears, as did BATS CEO Chris Concannon, who both looked forward to future issues in their remarks on the SEC approval.

There was far less consensus on the future of the DAO hack. One reason is that there is nobody in charge. That is something the public will have substantial difficulty getting used to. I believe they should not be expected to get used to it. There's nobody in charge of the internet either, but the internet does not replace the banks. It replaces the phone company and the post office.

But what is clear is that there is no clarity about whether the DAO hack even was a hack. If the DAO is code, are the measures of value, like DAO's ethereum, things that can be stolen by simply writing code that diverts it? The point of writing any code on DAO is to divert ethereum. But this diversion was a counter to the intentions of the founders of DAO. But if the DAO is "only code," why are the founder's intentions important?

Do these founders "govern" DAO? Until Friday, they said they don't. But the unilateral acts that they contemplate for "solving" the problem says they do. They intend to do this by consensus. Fine, but since the DAO is code, the whole idea of consensus feels ad hoc, and something governance should decide to do. Thus, the intention to "do something" is controversial.

And it points to the strong likelihood that if the cryptocurrencies, including bitcoin, do not concede that they cannot escape some form of rule of law and governance, they are dead in the water. If the cryptocurrencies do not find it within themselves to be "governed," the distributed ledger will need to walk away from the current cryptocurrencies to flourish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.