From: Robert Hettinga <rah@shipwright.com>
Date: Tue, 1 Apr 1997 17:39:54 -0800 (PST)
To: cypherpunks@toad.com
Subject: Re: Book-entry settlement mechanism
Message-ID: <v03020962af676350a5a6@[139.167.130.247]>
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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



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Robert Hettinga (rah@shipwright.com), Philodox
e$, 44 Farquhar Street, Boston, MA 02131 USA
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-----------------
Robert Hettinga (rah@shipwright.com), Philodox
e$, 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/