--- begin forwarded text Sender: e$@thumper.vmeng.com Reply-To: Robert Hettinga <rah@shipwright.com> Mime-Version: 1.0 Precedence: Bulk Date: Tue, 1 Apr 1997 17:27:59 -0500 From: Robert Hettinga <rah@shipwright.com> To: Multiple recipients of <e$@thumper.vmeng.com> Subject: Re: Book-entry settlement mechanism At 2:23 am -0500 on 4/1/97, Somebody wrote:

I may have misunderstood some of your points but here goes..

I doubt you're misunderstanding anything, as I'm usually making this up as I go along, anyway. :-). So, let's see what we have, here...

Your model assumes distributed settlement facilities provided by underwriters, issuers or transaction agents v the centralised model we have today.

Yes.

One of the problems with today's model is that there are too many centralised agencies ie euroclear, dtc, local clearing systems which are proprietary, complicating global settlement processes unnecessarily. Is distributed processing efficient?

*I* think so, if they all use the same cryptographic transaction protocols, which is what I've been talking about all along, here. If a cryptographic protocol breaks, the trade doesn't clear. I expect that settlement protocols, like internet protocols, will be open and standardized. That way, it doesn't matter who you're settling with, as long as long as their reputation is good. That reputation can be a distributed one, with a "reputation club", just like it is now. NASD membership, for instance, is a good present example. In the model we're talking about, if your key is signed by the club (association, syndicate, whatever) and not revoked, you're a member in good standing, so you're trustworthy for various kinds of transactions.

If I am a hedge fund buying a global portfolio of stocks I do not want to have to settle individually with the underwriter/issuer of each stock I purchase.

See above. You get your information from different web sites, now, right? No difference, to my mind.

As you say, the underwriter may well want to farm out this secondary market processing but I don't think transaction agents will offer that service for nothing.

In my example, they're selling the exaust, the pricing information they collect. New information is always more important than old information in a geodesic market, right? I say that secondary market transaction costs are still inconsiderable, for the most part.

Also because no one has critical mass for a clearing service I the investor end up paying over the top.

I think that you're looking at a world where there are economies of scale, here. As I said elsewhere, that "critical mass" continues to get smaller and smaller, particular in "switching" activities like trade clearing. One of my many groundless claims about all this is that the transfer price inside operating units of larger entities converges toward the market price between small independant entities. Exactly the opposite of what happens in industrial communications networks. Cf. all my various rants on Moore's Law and geodesic networks. The upshot is that organazitions map to their communication structures, and hierarchical, economies-of-scale markets and organizations don't work in that kind of world.

I also don't think it's more efficient for investors to pay transaction agents for the resulting price information - again if I am a global investor I don't want to pay for hundreds of different price feeds. Again you can see information agents entering the market but this is simply what we have today.

Yes, but the information is ubiquitous, and, of course, it's distributed geodesically. Anybody with a reasonably fast machine can purchase pricing from all those places, or even a reasonable statistical sample, and "publish" that information. More to the point, people with new pricing information will probably auction it off on a non-exclusive basis. Remember Cronk's geodesic information auction talk during the rump session in Anguilla? People with the most to gain from the newest information, pay the most for it, usually because they resell it to others, but also because they might need it to trade with.

'the operating costs of exchanging certificates for the secondary market is minimal'. Certainly it could be cheaper than it is today but minimal costs rely on the counterparties applying simultaneously and there being no hitches on the authentication.

Of course. "Assume a frictionless surface", and all that. However, just because the mathematics of the situation varies slightly from reality, doesn't mean that it's wrong. Physics versus Engineering. Frankly, I think that "no hitches in the authentication", being the most important business necessity for the underwriter, will have to be be the *first* thing to work. :-). Fortunately, that's not too difficult a problem with these cryptographic protocols. In addition, the operative clause in your sentence above is "certainly it could be cheaper than it is today". If it's "cheap" enough, and that is yet another unsubstantiated claim of mine requiring actual data :-), then it's good enough to use. H1 replaces H0, in statistical parlance.

How could investors sell short?

Same way they do now. By borrowing certificates from somebody, and paying the lender back with others. If the borrower doesn't pay those certificates back, it's reputation "capital punishment".

How would the clearer cope with back to back trades? How can we ensure that this technology is standard so that investors don't have to deal differently with each clearer?

See above. With a standard protocol. The internet is one big standard protocol, right?

I don't think your argument about seven years of audit trails etc is focused on net v book entry settlement but rather on the structure of the industry as it stands. The seven years of audit trails could stand equally in the new world since regulators might demand it (say they want to investigate a fraud) and you want some minimal regulation (do you worry about market manipulation for example?).

See <http://www.braintennis.com/> Suppose you could punish someone without needing the physical force of a nation state to do it. Reputation is orthogonal to identity in cypherspace. The ultimate sanction in a geodesic market is the loss of one's reputation. It's equivalent to capital punishment, because no one will ever trade with you again. And, the most important point, that reputation adheres to your digital signature, not your physical person. Biometric identity, audit trails, etc., are no longer necessary. So, if you can have non-repudiation through cryptographic protocol (to keep the trades from breaking, and, more to the point, to make them settle instantly) and reputation (to keep people from defrauding you), *what* exactly do you need market "regulation" for?

You could certainly simplify the current structure ie eliminate custodians, eliminate brokers, merge exchange and clearinghouse. But even with this new technology you would need to be able to reconcile your holdings against the underwriter (human error doesn't go away) and the underwriter has to keep an account of the holdings for dividend/coupon purposes.

Not if the coupons are actual certificates. For a bond and its coupons, you just issue a bundle of bearer certificates comprising the coupons and the principal. You could even "strip" them apart and sell them idividually in a secondary market, if you can find someone to buy them. :-). At redemption time, it would be just as if someone mailed in the little coupon they clipped off a paper bearer bond, only I send them digital cash, instead of a check. Don't need to know, or care, who they are. It's cheaper that way. For dividends, there are lots of different zero-knowlege cryptographic proofs that you can run using a digital bearer stock certificate, as the "information" that you want to prove you have. (See Bruce Schneier's "Applied Cryptography", 2nd ed., for this.) I call a dividend, people send me a hash (or something) of the certificate to prove they have it, and I send them digital cash in a message encrypted to them alone. Dividend paid, all on a bearer basis. You can do the same kind of thing for proxies, too. Yes, there are anonymous voting schemes. Welcome through the looking glass, Alice.

Finally, I'd like to understand how the investor gets best execution (agreed that he isn't getting it at the moment). How does your investor know he is getting best price?

Because he's picking the seller out of the equivalent of an open-outcry market.

How much structure will you impose?

The market imposes structure on itself. Economic reality is not optional. Reality dictates politics, not the other way around.

What is a more efficient way of providing price information and price history?

The most "efficient" way is the market's way. You know that. The more information you put into a market, the more efficient it is, modulo psychology, like motl^h^h^h^h greater fool theories, which we really can't do anything about, anyway.

PS I've been reading The House of Morgan (history of JP Morgan, Morgan Grenfell, Morgan Stanley etc) over the weekend. Although it is difficult to find the right balance, it is a useful reminder of the dangers and costs of unrestrained, unregulated capital and how we ended up with the today's regulatory structures.

I used to be a clerk at Morgan Stanley. My first job out of college. I read HOM about 5(?) years ago, after it came out. I read the book the same way you did, until I discovered this financial cryptography / geodesic market stuff. Now I see all that stuff completely differently. Morgan was "integrative", because that's the way communications technology was organizing things, into larger and larger hierarchies. I consider myself "disintegrative", because that's the way communications technology is organizing things, "surfacting" them into smaller and smaller entities on a ubiquitous geodesic market-network. By the way, my favorite J. Pierpont Morgan story is at the front of the book, where they haul him in front of Congress, after saving the US economy three(?) times and filling the mint twice(?), primarily because he has more money and financial power than God. :-). They ask him what is the most important thing to have to be a banker. His answer: Character. Something like, "Character. I wouldn't buy anything from a man with no character if he offered me all the bonds in Christendom." That's why we didn't need regulation in the original paper-based, instant-settled bearer certificate financial markets, the buttonwood tree on Wall Street, or the coffeehouse called Lloyd's, or a bunch of merchants in the City. Reputation ("Character") was good enough. It was a financial actor's most precious asset. Things changed from that, to the hierarchical, book-entry world we have today, because we needed to communicate long distances and had only humans to switch the information around. The technology you saw in Anguilla is about to change all that. I'll make one or my famous wild-eyed claims here, and say that the *only* reason we need market "regulation" is because our industrial communications technology required us to use book-entry settlement, which in turn required the force of nation-states to ensure non-repudiation. We don't need information hierarchies, much less book-entry settlement, anymore. Cheers, Bob Hettinga ----------------- Robert Hettinga (rah@shipwright.com), Philodox e$, 44 Farquhar Street, Boston, MA 02131 USA Lesley Stahl: "You mean *anyone* can set up a web site and compete with the New York Times?" Andrew Kantor: "Yes." Stahl: "Isn't that dangerous?" The e$ Home Page: http://www.shipwright.com/ ---------- The e$ lists are brought to you by: Intertrader Ltd - Commerce Solutions in the UK Visit <http://www.intertrader.com/> for details ... Where people, networks and money come together: Consult Hyperion http://www.hyperion.co.uk info@hyperion.co.uk Like e$? Help pay for it! See <http://www.shipwright.com/rah.html> Or, for e$/e$pam sponsorship, see <http://www.shipwright.com/rah/> Thanks to the e$ e$lves: Of Counsel: Vinnie Moscaritolo <mailto:vinnie@webstuff.apple.com> (Majordomo)^2: Rachel Willmer<mailto:rachel@intertrader.com> Commermeister: Anthony Templer <mailto:anthony@atanda.com> Interturge: Rodney Thayer <mailto:rodney@sabletech.com> --- end forwarded text ----------------- Robert Hettinga (rah@shipwright.com), Philodox e$, 44 Farquhar Street, Boston, MA 02131 USA Lesley Stahl: "You mean *anyone* can set up a web site and compete with the New York Times?" Andrew Kantor: "Yes." Stahl: "Isn't that dangerous?" The e$ Home Page: http://www.shipwright.com/