🟪 The Finance Robots are Coming

“The bottom line is that no one knows.”

— Franklin Edwards, author of a 3,000-page compendium of economic papers on the subject of what caused the 1987 stock market crash 

The Finance Robots are Coming

In 1987, Thomas Peterffy became the first person to connect a trading algorithm directly to a Nasdaq terminal, allowing his models to generate and execute orders without human intervention. 

The resulting surge in trading activity soon elicited a visit from a Nasdaq official, who deemed Peterffy’s arrangement an unfair advantage. 

To level the playing field, Nasdaq instituted a rule that all ensuing orders had to be entered into the exchange’s trading terminals via keyboards.

Peterffy, who later went on to found Interactive Brokers, complied by building a robot with nimble rubber fingers that speedily typed his algo-generated orders into the Nasdaq trading terminal.

Nasdaq, appreciative of the liquidity that Peterffy’s robot provided (not to mention the trading fees), soon embraced automation. The rest is history: The vast majority of stock market trades today are either generated or executed by algorithms.

The algorithmic revolution has not been without its hiccups, of course: That same year, 1987, is more famous for Black Monday, when the Dow Jones Industrial Average, for no evident reason, fell 22.6% — marking its biggest ever one-day decline.

We still don't know what caused the Black Monday crash. But we're pretty sure it had something to do with computers.

An AI-induced crash would be even more inscrutable.

Artisanal stock markets

AI bots cannot yet operate in markets without a human chaperone: They wouldn’t get past compliance departments’ KYC checks without a driver’s license, for starters.

And finding a bank to clear large trades is not easy: You will probably have to go see your prime broker in real life at least once.

But once they’re approved to trade, AI bots won’t really need humans. 

Last week, Ramp, a financial software firm, introduced a new offering, whereby its AI bot will analyze the business software products you use and then contact your software providers to negotiate lower prices on your behalf.

Soon enough, it'll be AIs on both sides of every financial negotiation: Your AI trading bot will negotiate margin fees with your prime broker’s AI, clearing fees with your clearer’s AI, exchange fees with the exchange’s AI, ….

And at that point, we will have no idea what’s going on.

I’m not an AI doomer: The most likely result is that AI, like Peterffy’s robots, will make financial markets more efficient, to everyone’s benefit.

But there's a tail risk that things go horribly wrong: Imagine, say, an AI trading strategy that learns to hack into corporate email systems and then trade on that information.

Large-language model AIs are inscrutable — there’s no telling why they do the things they do, even after the fact. So, we’d have no idea if some outperforming AI was trading on insider information.

Even the suspicion that it might be could be enough to undermine faith in markets.

And that faith would not be easily restored: We won’t know which AIs are the bad actors or have any real way to deter them even if we did.

If we don’t want to accept that tail risk, the only solution I can see is to “air gap” financial markets: Disconnect all the computers and go back to open-outcry floor trading with paper tickets and physical delivery.

We’ve got artisanal everything else these days. Why not artisanal stock markets, too?

Stress-testing DeFi

The AI bots will be coming for crypto markets, as well, of course.

But that might be good news: Transparent, deterministic DeFi could well prove more AI-resistant than opaque, unpredictable TradFi.

Cryptographic proofs-of-humanity may be more effective than human compliance departments in keeping adversarial AIs out.

And to the extent they get in, they may do less damage: DeFi markets may fare better against adversarial AI because DeFi is already highly adversarial.  

The rules of DeFi are enforced by code, which is stress-tested by attackers the moment it’s released into the wild. 

TradFi, by contrast, relies on regulators promising retribution — follow the rules or else — which seems unlikely to deter robots. Will robots have any fear of either prison time or social disapprobation?

There is no single point of failure in DeFi: Imagine if an AI attacker hacked the DTCC, the ultimate authority of who owns what stocks. TradFi would receive history’s biggest ransom note and we’d have no choice but to pay it. 

Fortunately, there’s no such weak spot in decentralized crypto markets.

But there are still plenty of smaller weak spots. 

So, we need more DeFi attackers, not less — and we need them now, before the robot attackers get here.

Because, as evidenced by Thomas Peterffy’s robot, there will be no keeping them out.

(Assuming my artisanal markets idea doesn’t catch on.)

— Byron Gilliam

Top Stories

1. Ex-BNY Mellon Exec: ‘Vague’ Crypto Security Regulations Are Ideal — Read 
2. Hong Kong Expected to Lift Crypto Retail Trading Ban Next Month— Read
3. Ledger Recover Delayed Until Open Sourcing Is Available — Read 
4. Bitcoin’s Looking Less Lively These Days — and That’s Bullish — Read
5. Coinbase Files Mandamus Petition in Response to SEC — Read

Daily Insights

So, how'd we do? Provide your feedback on today's edition of Blockworks Daily below.

Written by Byron Gilliam

Produced by Francisco Caeiro

Follow Blockworks on Twitter, LinkedIn, YouTube, Telegram and Instagram.

Was this email forwarded to you? Sign up for free to join over 180,000 investors who read Blockworks newsletter daily.