Remember when the Internet was supposed to democratize everything? Create a level technological playing field where ideas and commerce would frolic in their natural glory in a land of free intellectual exchange and scarcity-free splendor?
As we’ve seen multiple times, this utopian vision has succumbed to more pedestrian physical and commercial realities. The Internet is not free, and is in fact expensive to build, run, and maintain. Moving publications online introduces fixed costs that are harder to manage than the variable costs of print. And online commerce is just as susceptible to power laws as ever, perhaps even moreso.
In the land of open access (OA), which harks from the days of idealistic splendor, we now see the big commercial publishers benefiting the most, a fact which was confirmed recently when Cambridge released data on its APCs, and the winner yet again was Elsevier.
The Internet may have brought us forward in the world of physics, but while it is faster and has greater capacity, both its speed and capacity remain finite. Finite things are not endlessly abundant, and the resulting scarcity is something a few clever folk have found interesting new ways to exploit.
If you’re a non-profit publisher with an investment fund or endowment to manage, or a for-profit publisher with stock prices to worry over, you need to know about how the scarcity of the Internet is being exploited today.
The first instance concerns Bitcoin, a peer-to-peer cryptocurrency that relies on cryptography algorithms to control its creation and transfer.
The second instance concerns “flash traders,” or high-frequency traders on the stock market. Well, on the market they’ve created within the stock market.
What do Bitcoin and the flash traders profiled in Michael Lewis’ superb new book “Flash Boys” have in common?
They both make money by exploiting scarcity in the Internet’s infrastructure, along with a pervasive ignorance of computers, networks, and the physics of fast electronics.
Bitcoins are “mined” by an algorithm running on processors. If you have more and faster processors, you can mine more Bitcoins. Entire data centers have been taken over or built to mine Bitcoins. The scarcity users of this cryptocurrency have to overcome is scarce processing speed and capacity. Overcome these sources of scarcity, and you can literally “make” money, even if its ultimate value remains dubious. Without this scarcity, Bitcoin doesn’t work. It has to be somewhat hard to “mine” or it doesn’t have value.
The “flash traders” Michael Lewis has described exploit scarcity in a different way. Light travels at 186,000 miles per second, or 186 miles every millisecond. If the Chicago exchange is 700 miles from Newark, it takes about 5 milliseconds for a signal to move between the two locations — in a vacuum. But through imperfect fiber optic cables, it takes more like 20 milliseconds. Unless, of course, you have an optimized line, where the time can shrink by 5-8 milliseconds. With this speed advantage, a flash trader can offer a few shares, detect when a big firm is hunting for shares, and move the market in the few milliseconds gained. After all, a computer can execute 100 or more trades in a millisecond. Having grabbed the shares at a lower price, the flash trader sells them at a higher price almost immediately, making millions off these small margins over the course of a year. This is called, “high frequency trading.” Significantly, these traders take no risk in the market, as this passage illustrates:
In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experienced just one day when it hadn’t made money, and that the loss was caused by “human error.” In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses. This sort of performance is possible only if you have a huge informational advantage.
Entire black pool exchanges exist in New Jersey and now Chicago in order to create a stock exchange hidden within the stock exchange, their speed advantages imposing a transaction tax on nearly everyone buying stocks today. Called “front-running,” this type of behavior is illegal if humans do it, but not illegal if humans do it through computerized transactions that gain an informational advantage through clever snares and faster connections.
As Mark Cuban describes flash trading or high-frequency trading, it is:
[t]aking advantage of an advantage in speed and algorithmic processing to jump in front of trades from slower market participants to create small guaranteed wins millions of times a day
In both cases — Bitcoin and flash trading — we are seeing the tyranny of superior technology that differentiates on scarcity. Have more computers in a Bitcoin economy? You can run the cryptographic algorithms faster, and you get rich. Have more bandwidth in today’s stock market? You can tax every other trader in the market without their knowledge and become rich.
Besides exploiting technical scarcity, another thing both Bitcoin miners and flash traders have in common is that they are already, by almost any standard, rich. These are just schemes to use technology to baffle other people while they attempt to get richer. So, instead of technology being a democratizing and leveling social good, it is being turned into a tool to exploit, deceive, and defraud. The Matthew Effect — the rich get richer — strikes again.
Michael Lewis states bluntly that flash trading (or high-frequency trading) has created a stock market in which flash traders are predators, luring normal investors — the prey — into hidden traps. Luckily, one of the people who first figured out the scam has started a stock exchange that defeats the predators — IEX. It’s the only place where you can buy stocks without being victim to flash traders.
It took me a while to puzzle out what Bitcoin represents in the abstract — mining scarce computing power with an algorithm tuned to create sufficient scarcity using today’s technology to make that look like value. Michael Lewis and the heroes of his story figured out another important technology game going on.
Technology is not innately good. It can be misused. It can be used to exploit, constrain, pry, and fool. The answer is not in technology. It is in culture, law, and shared expectations of fair play.
Discussion
7 Thoughts on "Bitcoin and Flash Traders — Leveraging Scarcity Within the Internet's Infrastructure"
Reblogged this on The Student Becomes The Teacher.
I must disagree with your analysis of Bitcoin on a few points.
There is no central authority to fractionally reserve anything with Bitcoin and it was designed from the ground up to prevent that from happening. That is the whole point of bitcoin, to avoid central control. Mining is NOT a winning proposition either for most regular folk. I know, I mine. Believe me I am NOT going to get rich mining bitcoin, nor was I rich when I started. No one without tens of thousands to spend will become rich either. In fact, from what I have seen, it is doubtful mining is profitable in the long run at all – no matter what anyone spends on it.
Also, Bitcoin may not survive. If the market finds a better alternative the game is up.
Plus, the data centers you speak of were not taken over. They were built from the ground up from nothing. The equipment to mine didn’t even exist a few years ago. The people who built them put extreme amounts of capital down, up front with no guarantee of ever getting it back. They have no control over weather Bitcoin is adopted or not by the general public as a currency. Again, where is the control?
I mean we’re speaking about a currency that grew out of a set of political views that despises authority and centrally controlled nation states and you are telling me that these very people are going to want some “bankster” (their word not mine) to come in and control it?! The odds of that happening are greater than winning the lottery – not too good!
In fact the major debates right now are between the venture capital types and the anarchists over regulations and taxes. it will be interesting to see who wins. My guess is there will be compromise that the anarchists are very unhappy with, but the demand for an alternative to the very banking system you propose these anarchists will pine for is so great that the anarchists are going to get pushed aside by free market demand. These computer geeks and crypto-anarchists designed it almost too good and bitcoin – or something like it, is going to become as mainstream as the TCP/IP stack and HTTP protocol.
Whatever the outcome, the concept is loose. The genie is out of the bottle and nature abhors a vacuum. This new form of money transfer is here to stay, like it or not.
GIven the outsized advantage leading edge technology can bring to a business, it’s a bit odd that the publishing industry is still reminiscing over the days of print and outsourcing all their IT.
I think that it is important to note that this kind of scarcity is artificial. Like the cartel that makes diamonds scarcer than they actually are, it requires at least the tacit acquiescence of those who could easily unplug any and all artificial scarcity machines by changing law, policy, etc.
Interesting article, but your point could be defined better in my opinion. Unlike stocks, digital currencies are more readily used in transactions. Case in point: https://www.gocoin.com . It, like Bitpay, processes digital currency payments like bitcoin, litecoin, dogecoin etc. into fiat currencies like USD/CAD/EUR and more. Not only that, digital currencies are the only current way to make a payment around the world almost instantly. You can’t say the same with Western Union, Paypal, or doing a Wire transfer. Those methods are highly regulated, with fees, and a lot of times not even possible.
HFTs have their own issues as well and operate on their own playing field in the shadows. They absolutely have an advantage over everyone else as they are algorithms that have near real-time access to market information and can react in milliseconds, unlike your average internet trader.
To your last point, technology is a tool. Like other tools, they are not innately good or evil, it depends on how it is used.
High frequency trading drives down the spread, making investing actually cheaper for most of us—it’s not quite the unalloyed evil that Lewis portrays. He’s received a lot of criticism for his book.
