I wonder if anonymous digital cash will really consist of shares in frozen orange juice futures... John Date: Fri, 15 Apr 1994 06:55:58 -0400 From: farber@central.cis.upenn.edu (David Farber) Subject: The Soft Pork Underbelly of Efficient Markets [I knew electronic markets were good for something .. djf] To: interesting-people@eff.org (interesting-people mailing list) Date: Thu, 31 Mar 1994 23:30:20 -0500 From: Peter Wayner <pcw@access.digex.net> Subject: The Soft Pork Underbelly of Efficient Markets The Under Pork Belly of Efficient Markets, or How to Launder Money Using Cattle Futures The great promise of electronic networks and virtual communities is a collection of very efficient markets. In the future, information will be moved, products will be sold and trades will be executed in a blink of an eye. This efficiency is usually considered to be a pretty good thing by everyone in business, in economics or in line at the video store. The underside of this efficiency, though, is a blurring of the line between legitimate and illegitimate business. A good way to understand this effect is to study the case of how to launder money using the futures markets. Laundering money is an age old problem for people who want to move funds from person A to person B without leaving a suspicious trail. Cash is the nieve approach and it has plenty of problems: it is bulky, it can be lost or stolen, and most importantly it often leaves people asking "Hey, where did that come from?" The futures markets, though, make it simple to move funds in a way that is indistinguishable from ordinary commerce. If it is done correctly, the recipiant, person A, looks like a lucky stiff or a market savvy investor. Person B is usually out of the picture or out of luck. The same games can be played with almost any other market, but futures markets are so efficient that the process is actually feasible and easy to do. The basic transaction in futures is to buy or sell a contract for the delivery of x pounds/barrels/tons/feet of some commodity at y dollars/yen/marks etc. If you buy a contract, then you're obligated to actually cough up y dollars when the contract comes due. Most people don't hold on to the contracts long enough for them to actually take delivery. They sell another contract and the futures market maintains a clearing house that is responsible for matching up the contracts and cancelling them out. It's a great system. Very efficient and very useful for farmers, manufacturers and others who actually produce and consume commodities. Futures markets are great for laundering money, though, because they can generate big losses or big gains in a short amount of time. It is quite possible for $100 to turn into a $5000 gain overnight. The downside is that it can often turn into a $5000 loss in the same amount of time. In fact, the market is a zero sum game. If you make n dollars, then there is someone out there who just lost n dollars. The sum total of the losses and the winnings equals zero. This zero sum nature is the key to laundering the money. Person A and Person B get together and guess that the price for a commodity is going to go up. That means that who ever buys a contract will make money. So Person A, the intended recipient buys a contract and Person B sells a contract. If they're right, then Person A gets the money and Person B loses the same amount. Bingo. The money moved from B to A and no one can trace how it got there. Person A looks smart or lucky and Person B looks out of luck. There was no direct connection between the two. There are thousands of other people out there winning and losing money at the same time. The marketplace's central clearing house arranges it so each wins and loses their rightful share. You may wonder why B bothered to sell a contract and lose money. This is the safeguard against guessing wrong. No one is correct all of the time. Even the people who try and rig the markets and corner them get burned as often as they succeed. The best investors in the futures markets, the ones who make money time after time, are the arbitrageurs. They spot inefficient pockets and try and remain neutral to the overall shifts in the market. Person B sells the contract so that if the market goes down, i.e., the wrong way, then A and B together have lost no money. It's a zero sum. Now they just have to play the game a bit longer or for stakes that are twice as high. You can think of the process as flipping a coin until you have encounter a heads. Ideally, you play this game with two players with relatively deep pockets. This means that A can cover the short term loses. This is a bit of a disadvantage because many money laundering operations must move cash from the rich to the poor. You can cover up this problem by using the same broker for A and B. The broker executes the trades and then assigns the winning trade to A and the losing trade to B. They fill in the order books after the fact. Using the same broker for A and B can be problematic because it may look too suspicious if the mirrored trades appear on the same ledger. The beauty of this system is that it can look quite indistinguishable from normal business practices. Many companies actively enter the futures markets to hedge themselves against foreign currency movements. Others actively enter the futures markets to guarantee themselves a good supply of their raw materials. The essential point of this lesson is that fast, efficient markets make it possible to move money easily. The futures markets were designed so that is no real other half to every trade. It's literally you against the world with every trade. The RISKS, of course, is that accountability can vanish as the size of the crowd grows to be as big as the world. There is no way to catch up with this. The futures market are so great because there is no need to deal one on one. The effects of speed are not only apparent in big financial markets. Credit cards and overnight delivery are a dangerous combination. You could steal cards, order a fortune of stuff, arrange for it all to be delivered overnight and then jump town quickly before people notice the card was gone. Suddenly, merchants must deal with the fact that something that used to be complete legitimate (exchanging cash for goods) is now a potential theft. Of course, there are other crimes that lose their edge. It is much harder to escape the law by heading to a new town. Computerized fingerprint files are very, very efficient. I think everyone felt that perfect, computerized markets would bring about the right mixture of accountability and efficiency. It would be a perfect mixture of Big Brotherly scrutiny would take care of everything. Every trade, after all, is recorded in the futures market. Yet, the best mechanism for anonymous fund transfer yet discovered exists here in the midsts of all of this record keeping, legal scrutiny and oversight. ------- End of Forwarded Message