Many people were shocked -– shocked! -- by reports this week that some on Wall Street are trying to get what may be an unfair advantage by engaging in high-frequency trading.
Please. Yes, markets can be rigged. But leveraging speed to exploit information asymmetries has been central to financial markets since their inception.
Just look at the early 1790s, when Alexander Hamilton became the first secretary of the Treasury. Hamilton, of course, is best known today for solving a serious debt problem, consolidating a vast overhang of IOUs incurred during the American Revolution into a new, national debt.
Most of these instruments -– loans, certificates and a range of paper promises issued during the Revolution -– were worth a fraction of their original value, largely because no one expected them to be repaid.
But that’s what Hamilton proposed to do. As he formulated what would become known as the Funding Act of 1790, he argued that the federal government assume the full face value of the various bonds and certificates issued by the Continental Loan Office, along with the various IOUs issued to discharged soldiers and the many debts incurred by state governments. These could be exchanged at a one-to-one rate for new, interest-bearing Treasury bonds issued by the U.S. government.
Word began trickling out among New York's financial elite that the government might end up buying up piles of almost worthless paper at full face value.
Speculators, recognizing an astonishing opportunity for arbitrage, headed for the countryside, where news of the plan hadn't reached. Here's how a historian of Wall Street described what happened next: “The wily hastened to the highways and byways and bought up, at remarkably low prices, the Government ‘stock’ held by ignorant men who did not dream that it could be redeemed at par.’”
The fleecing continued after Hamilton’s plan became public. One critic in Congress, likening arbitragers to “rapacious wolves seeking whom they may devour,” told tales of ships filled with speculators leaving New York for the Southern states to buy up debt from the ignorant and credulous.
In the succeeding years, speculators continued to act on the principle that if they could see price discrepancies before anyone else, they could make a profit. It was that simple.
The Americans were hardly the only ones to do so. The Rothschild banking empire, for example, was believed to have profited handsomely from the Battle of Waterloo in 1815, using carrier pigeons to transmit Napoleon's defeat to buy British bonds before news of the outcome hit London.
Sadly, this story is apocryphal, as historians such as Niall Ferguson have demonstrated. But the famous banking family did use carrier pigeons to get information ahead of the competition, along less exotic methods, such as speedy couriers mounted on horses.
In time, the Rothschilds pioneered codes carried by the couriers (the bird variety). As one member of the family explained to his brothers: “A B in our pigeon dispatches means buy stock, the news is good. C D ... means sell stock the news is bad. I hope our feathered messenger will have brought you in due time our good prices.”
A more reliable tool for arbitrage was the so-called Chappe telegraph. This system of communication relays designed by a Frenchman named Claude Chappe was a precursor to the modern telegraph. Each line consisted of signal towers built every 10 to 20 miles. Operators in each tower kept their eye on the adjacent towers through a telescope. Using semaphore signals, they could send messages at what was then considered a staggering speed.
For example, while it took several days to travel from Paris to Bordeaux, a message could be transmitted via the Chappe telegraph in only a few hours. In the 1830s, two clever bankers, the brothers Francois and Joseph Blanc realized that they could bribe the telegraph operators at a station not far from Paris to send a bogus signal, in essence, an error followed by a message canceling the error.
The sequence of these errors functioned as a code. Certain sequences indicated where prices and rates of governments bonds in Paris were headed. Just outside Bordeaux, the brains behind the scheme -– a former telegraph operator named Pierre Renaud -- kept watch on the relay station, which faithfully transmitted the errors and the corrections. Renaud used the information about what was happening in Paris to place bets in the Bordeaux market.
The Blancs made a bundle before being found out, though they escaped prosecution (they hadn’t, it turned out, broken any laws).
In the U.S., investors may have used similar systems. As historian Richard John recounts in "Network Nation," speculators built an optical telegraph line between New York and Philadelphia. According to one journalist in the 1840s, “It was a great affair when first established, and many mysterious movements in the Philadelphia stock and produce market were laid at the door of the speculators who worked the [optical] telegraph. No doubt the speculation paid them well.”
But in 1846, the arrival of the electric telegraph radically altered markets. It had the potential to move markets from the material world of endless arbitrage into something approximating a virtual world of perfect information.
That was the theory. In practice, the telegraph simply enabled a new generation of sharpers to exploit the new technology for speculative ends. As recounted by historian David Hochfelder, telegraph superintendents used their privileged position as gatekeepers of information to make fortunes speculating in gold and other commodities.
In succeeding decades, successful arbitrage relied on ever smaller discrepancies in time and knowledge. What once played out in weeks and then days now transpires in milliseconds. The high-frequency traders now under investigation by the Federal Bureau of Investigation are only the latest in a long line of speculators who have gamed the system. And it is likely the next innovation has already been invented.
(Stephen Mihm, an associate professor of history at the University of Georgia, is a contributor to the Ticker. Follow him on Twitter at @smihm.)
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