- 1998: Volume 7, No. 4 A Golden Age of Trading

MAKE MONEY FAST!! The e-mail goes on to explain the sure-fire investment in a Costa Rican poultry farm or (my favorite) a time machine. And the investment yields a guaranteed 50 percent annual return. Of course.

As one top securities cop said, "if you can reach 30 million people with a stroke of a keyboard, a con artist would be crazy not to use it." This is the crude face of the new financial internet. At the other end of the spectrum, however, the internet is beginning to change the structure of markets and the financial services industry beyond recognition. Just as earlier this century the automobile changed our society, the geography of the land and the shape of cities, the effect of the internet will be far-reaching; and no industry will be less affected than that of finance.

One of the main agents for change will be the humble personal finance program that people run on their PCs. Although still fairly simple, these programs will evolve into full-time financial managers that, among other things, check optimum bank rates and swap money automatically between accounts, and also monitor the overall risk of investments and, again, trade automatically to re-balance the portfolio. The trend is there already, but increasingly one will find that the trader on the other side of a deal is not a person but a computer.

Free Price Data

We hear that the net is delivering "friction-free capitalism," and certainly many costs should fall as producers have direct access to consumers and investors direct access to markets. In fact it is difficult to see why the costs of certain services will not fall to zero. For example, the cost of price data has been falling for some time, driven down by strong competition and cheap internet distribution; and the cost may fall to zero as exchanges believe their future lies in boosting turnover through making their prices as widely available as possible. For traders this is good news, but for many ordinary investors this may be a mixed blessing (not so comfortable for the information providers as well). We might find brokers pushing free real-time prices to their clients, encouraging them to emotionally over-trade. Free real-time prices as the designer drug of the X generation?

There should be a similar fall in trading costs, as traders either interact directly with the market, or use brokers whose efficiency has increased to such a point that they become mere cash management operations. An interesting side-effect of the decrease in trading costs for small operators, may be that arbitrage-previously reserved for investment banks-becomes viable for the common man. Arbitrage requires very cheap and quick access to the markets; two factors that, until now, were denied the ordinary investor. However, with real-time prices delivered to the home PC, and low trading costs, things might change. In fact, it could be that the pendulum swings in favor of the small operator, who does not carry the costs of back office staff and city office rents.

Research

Another area that will be affected is research. As the number of direct traders and investors in markets increases, many technical analysis theories may become more relevant (operating, as they will, within a greater and more representative universe). However, it is not only the universe of traders that will expand, but also the range of data to be analyzed. At the moment, technical analysis is almost exclusively applied to numerical data (i.e. price data). But imagine if computers could capture and analyze text data as it appears in daily newspapers, screen-based newsfeeds or online chat forums. This is the nascent science of natural language processing, and could open up an enormous new field of possible analysis, where it might even be possible to apply technical tools to text histories. As everything becomes digital, it becomes easier to analyze potentially correlated phenomena such as market activity and news propagation.

I don armour, and tread warily onto the next issue: gambling. This is not an uncontroversial topic, nor a new one, but it seems to me that the differences between investment and gambling have always been rather more illusory than real. The idea that the two activities are separate may have served a useful purpose for a period, but the growth of digital communication is about to eliminate any subtle distinction. Mentioned before is the personal finance program that will monitor our investment portfolios, but the portfolios will also include our gambling stakes, and the risk module will analyze, for example, the correlation of our sports bets with market exposure. If we bet on Denmark winning the soccer World Cup, that might be hedged with a short position in the Tele Denmark ADRs trading on the NYSE. Such correlations will become increasingly common, and then, obviously, reinforced as the market recognizes the phenomena.

Games

The three most vibrant sectors of the internet are finance, games and sex. While it is difficult to see where the cross-over might be between finance and sex (although this might be merely my lack of imagination), the link between games and finance is likely to grow stronger. Already, financial markets themselves are merely one facet of multi-player gaming, and it would be odd if some of the lessons learned from the interactive online games (lessons learned more easily within an artificial, controlled environment) did not find some application for traders. And beyond the general theory of human interaction, trading activity may be able to borrow ideas from the actual technology of games. For example, rapid 3-D representations of complex environments or more sophisticated interfaces with computers-beyond the 100 year-old kludgy technology of typewriter keyboards.

One of the most unruly corners of the internet is the chat room (or discussion forum, bulletin board). These are online meeting places where people can swap messages directly with others. Originally developed perhaps with the idea of promoting learned discussions on, say, molecular biology, thousands of forums quickly appeared covering topics of significant, and some not so significant, interest. Including many investment-related forums, which contain everything from useful contributions from company insiders to banal stock trash talk. As yet, no-one is sure who is responsible for the talk on these forums, the users themselves, the owner of the chat room or the ISP. But in these early stages it is not difficult to see the similarities with the growth of markets in, say, ancient Greece, where one has a critical mass of people coming together to discuss the value of some asset or contract. And, naturally, it would not be surprising if buyers and sellers began to trade within these forums, without the costly intermediation of brokers and market makers. This is not quite as chaotic as it might at first appear, if there exists some clearing organization to effect the trade settlement. If this took off, it could grow very quickly, with mini-exchanges appearing on all types of web sites. It could be that some web sites offer a wealth of investment information for free, while paid subscription is required for access to the forums where discussion and trading takes place. Existing web sites such as Silicon Investor (www.techstocks.com) would seem obvious candidates where mini-exchanges could develop around a particular interest area (in this case high-tech stocks). In addition, we might find that smaller companies find it expedient to set up stock trading bulletin boards on their own web sites rather then list expensively on an exchange.

The Decline of Stock Market Capitalism

The most fundamental change though may be in the future role of capital and stock exchanges. In the industrial era, companies required massive amounts of capital to fund the building of factories, administration systems, sales networks etc. But as we move into the information age, the new hi-tech, growth companies do not have such a demand for capital.

Thus, we have stocks like Yahoo with a small float being bid up enormously, as investors try to get exposure to an essentially small company. But these investors will increasingly find it difficult to get consistent returns on their capital within the stock markets, as the real action will be taking place elsewhere. They will become frustrated by the difference in their stock portfolio appreciation, and all the business action they hear about in hot sectors. And so they will be driven to proxy investment in these hot sectors-in effect to the derivatives markets. A whole range of new type of derivatives could blossom to exploit this-there is no reason to suppose that our choice of investments a few years hence will be largely limited to stocks, options and futures. Hybrid investment vehicles could appear with little resemblance to anything before. And these vehicles may no longer be restricted geographically (i.e. trading on a specific exchange) or within a particular regulatory framework. To enable identification and analysis by investors each hybrid may carry the equivalent of a bar code on a food wrapping, detailing its contents, e.g. volatility (protein amount), margin (carbohydrates), exercise style (grill or boil), expiration (sell by date). Such hybrids may allow investors to take a view, for example, on the performance of a company with a contract linked directly to its sales or earnings growth.

Sayonara Government Regulation

To much of the above, wise owls may respond, "harrumph! the authorities will never allow it." But the power of the authorities to control much of this may be slipping out of their hands. Naturally, the last people to accept this will be the politicians and officials themselves, those vested with overseeing the markets-it is always uncomfortable having responsibility without power. It will take a little time for people to realize this, and in the meantime there will be many calls on the law-makers to "do something" about the anarchic internet. However, internet regulation is like nailing custard to the wall; shady activity on the net can quickly and easily disappear over borders. This might lead to calls for "international co-ordination" of securities regulators, but, even in the unlikely event of agreement among a critical mass of the world's nations, they will forever be fighting yesterday's battles-by the time legislation is passed, the net will have moved on.

The only feasible solution to this would seem to be caveat emptor-buyer beware! This idea is commonly viewed as a callous abandonment of children and widowed currency traders to the wolves. But it does not have to be so. Today, computers and software agents can replicate much of the "safety checks" for investment activity, which can be further bolstered by educational and data support from pared-down government agencies and also advice from independent companies offering a range of services including access to scam check databases.

If only a fraction of the foregoing speculation comes to pass, is this a good thing? Who knows. But if people are queuing up to put their money into time machine bonds, then, for those that can follow the disciplined rules espoused in this newspaper and elsewhere, we could be entering a golden age of trading. Modem owners of the world unite. You have nothing to lose but your trading costs!

Stephen Eckett has worked for Baring Securities, Bankers Trust and S.G. Warburg Securities in London, Hong Kong and Tokyo. In 1993 he founded Numa Financial Systems Ltd (www.numa.com)-a derivatives and technology consultancy. In the last few years he has become increasingly involved with the internet and co-founded the Global Investor Bookshop (www.global-investor.com)-the world's largest online financial bookstore. He lectures on investing and the internet and is the author of Investing Online, published by Financial Times Pitman Publishing (order number 800-462-6420). The book recently won two Benjamin Franklin Awards announced at the 1998 Book Expo America in Chicago. (Further details of the book can be found at www.global-investor.com/book). He can be contacted at se@numa.com