One of my favourite books, and the book that made me go into trading, is Edwin Lefevre’s ‘Reminisces of a Stock Operator’. The semi-biographical account of Jesse Livermore’s career, a trader at the turn of the 20th century, who would have made a killing in today’s largely unregulated cryptocurrency markets.
Looking at what is happening in crypto today; I can’t help but recall one of the passages that stuck with me since I first read the book over a decade ago:
“When you read contemporary accounts of booms or panics the one thing that strikes you most forcibly is how little either stock speculation or stock speculators to-day differ from yesterday. The game does not change and neither does human nature.”
He said this in 1900.
“I used to think that people were more gullible in the l860’s and ’70’s than in the 1900’s. But I was sure to read in the newspapers that very day or the next something about the latest Ponzi or the bust-up of some bucketing broker and about the millions of sucker money gone to join the silent majority of vanished savings.”
If this doesn’t describe the crypto market, I don’t know what does.
The more I thought about it, the more I had flashbacks to my classes in university on political economy and the history of economics — no matter what time we’re living in, JL’s words (as he liked to be called) keep popping up in my mind:
“ The game does not change and neither does human nature.”
The crypto space is a lot like the derivatives and stock markets of centuries past.
The history of derivatives is as old as the history of commerce, with a promising hypothesis that Sephardic Jews carried derivative trading from Mesopotamia to Spain during Roman times and the first millennium AD, then to the Low Countries in the 16th century.
It’s thought that derivatives played an important role in the funding of long distance trade; for example sesame plants were cultivated in the Indus Valley between 2250 and 1750 BC. A tablet from 1809 BC documents a Mesopotamian merchant borrowing silver, promising to replay it with sesame seeds “according to the going rate” after six months. This contract combines a silver loan with a forward sale of sesame seeds.
On the European side, Greek ascendancy began around 1000 BC, and although Greek law favoured spot transactions, this does not prove that there were no contracts for future delivery because commercial history is littered with laws and edicts against derivatives that were ignored by the public. This is a point that I will be touching on multiple times.
The Romans were heavily influenced by Greek culture, and by the 3rd century BC, Roman law caught up with commercial practice, providing for contracts for future delivery of goods. It’s easy to see how today the law will quickly catch up with commercial practice as ICOs and tokens are legalized and legitimized further.
Fast forward a millennium or so, and Amsterdam became the leading commercial center in Europe, with its golden age lasting from 1585 until the mid 17th century. It was the first city where derivatives that were based on securities were used freely for an extended period of time.
The formation in 1602 of The Dutch East India Company was met with public enthusiasm, which turned into disenchantment when the company developed more slowly than expected. The share price doubled within a few years, but roughly 75% of the gain was lost by 1610. In response to the disappointing performance of the Company, Isaac Le Maire, conducted the first recorded bear attack in history by selling its shares short. I’m sure anyone reading this can point to at least a handful of ICOs and blockchain based startups with a similar story.
1621, 1630 and 1636, saw edicts issued with the intention of undermining contracts for difference by making them unenforceable in the courts; this did not prevent the use of contracts for difference during the tulip-mania however. Derivative contracts continued to work because the failure to honour a contract made a speculator an outcast, practically excluding him from further trade. In many ways this is a parallel to the attempt of counties like China to ban cryptocurrency trading by first limiting ICOs, then exchanges and most likely all cryptocurrency until they take control of it. But as history shows, activity will not stop.
In 1711 the British (government) took part in the formation of the South Sea Company, the success of which led to a wave of new joint-stock companies with dubious business plans, which tried to cash in on the public’s seemingly insatiable appetite for shares. This is strikingly similar to the situation that presented itself in the early 1990s with the dot-com bubble and what is happening today with the blockchain-bubble. I say blockchain-bubble because most people refer to this being and ICO bubble; the reality is there are a large number of blockchain based solutions looking for a problem, and almost all are looking to cash in on the public’s appetite.
A ‘significant’ event took place in 1734; the British Parliament passed the Sir John Barnard’s Act, which declared contracts for the future delivery of securities to be “null and void”. Adam Smith realized that the Sir John Barnard’s Act did not prevent derivative trading: “Persons who game must keep their credit, else no body will deal with them. It is quite the same in stock jobbing. They who do not keep their credit will soon be turned out, and in the language of Change Alley be called a lame duck.” — And so, for the first time since leaving university, I quote Adam Smith…
As a consequence of the act, Great Britain moved to a system of derivative trading with securities that was based on reputation, similar to that in Amsterdam a century earlier. This is similar to the crypto space, and why it is important that the cryptocurrency community creates a self-policing, self-regulating framework, which is happening to an extent, even before governments get involved.
Not much is known on the use of derivatives by banks, but there is reason to believe that banks were at the forefront of derivative trading during the 18th and 19th centuries. In the present day, I would expect institutions to start embracing cryptocurrency more and more, particularly as formal legislation and regulation comes into effect, as demonstrated by past activity.
Now that the history is out of the way, let’s look at the way people behaved in these markets. And like the slave whispering “memento mori” in Caesar’s ear, I have Jesse Livermore’s words echoing in mine. “The game does not change and neither does human nature.”
One author (Anonymous 1720) writes: “Everybody knows that the chief business of stock-jobbers consists of selling out of one stock, and buying in another, as particular circumstances at home or accidents from abroad may lessen the value of one, and raise that of another”. The news was so well anticipated that De la Vega (1688) notes the “expectation of an event creates a much deeper impression upon the exchange than the event itself”. Reading this, it’s still amazing to see how little behavior has changed, irrespective of technology, to 300 years ago.
In regards to bubbles, contrary to popular modern perceptions, investors in the 1700s, and even at the height of the South Sea Bubble, used fundamental-based valuation techniques that are strikingly similar to those of today. Such valuation methods won’t establish that a bubble is rational, only that the economic principles underlying the market analysis and valuation were well understood by investors almost 300 year ago.
All this leads nicely to the next and possibly most important nuggets of wisdom that can be inferred from the history of stock markets and derivatives; governance and regulation.
Mortimer (1801) notes that in the early stock market in London there was substantial risks of non-payment and fraud. According to Hobbes’ thinking (aka ‘Hobbesian theory’), we should expect markets to develop only after authorities have designed and implemented rules or regulations to eliminate these risks. Historically, however, there is a lot of evidence to back up the argument that solutions to these problems did not come from the state.
The London Stock Exchange was created by 18th century brokers who transformed coffeehouses into private clubs, which in turn created and enforced rules. Rather than relying on public regulation to enforce contracts and reduce fraud, brokers consciously found a way to solve their dilemmas by forming a self-policing club. By the same ‘token’ (… I’ll see myself out…), it is up to the crypto community to create and enforce rules which combat bad actors.
Hayek wrote (1960), “the value of freedom consists mainly in the opportunity it provides for the growth of the undersigned, and the beneficial functioning of a free society rests largely on the existence of such freely grown institutions.”Fundamentally, choice, allows groups of freely associating individuals to discover new ways of governing their conduct. The existence of individuals and groups simultaneously observing partially different rules provide the opportunity for selection of the more effective ones.
As more and more ICOs and blockchain based startups are coming to the fore, a process is slowly being created and followed by everyone with the odd variation here and there. AML/KYC/CTF checks are more ‘professional’, entities are sure to not break securities laws and excluding members from certain jurisdictions from taking part. The process is Darwinian, but at the speed of light.
It was clear stock brokers were not welcome at the Royal Exchange after the 1696 act “To Restrain the Number and the Practice of Brokers and Stockjobbers”. This act was to regulate and license brokers but they were able to avoid it merely by leaving the Royal Exchange. 18th century writer Thomas Mortimer (1801) wrote the “usual rendezvous of Stock-jobbers was Jonathan’s Coffee-house, in Exchange Alley”. Various coffee houses provided customers with a meeting place that appealed to different types of people; writers and critics went to Will’s, philosophers went to the Grecian. White’s Chocolate House attracted gamblers, and Lloyds’ Coffee House, which later became Lloyd’s of London, specialized in shipping and marine insurance. Now, this is no different than what we’ve seen with jurisdictions like China banning ICOs and exchanges; in response, many exchanges have simply relocated.
Interestingly enough, one of the biggest problems historically was deliberate fraud. John Houghton wrote in 1692 “Without a doubt, if those trades were better known, ‘twould be a great advantage to the kingdom; only I must caution beginners to very wary, for there are many cunning artists among them” This may as well have been written yesterday, and referenced ICOs. As we’ve seen the SEC is going to open the flood gates soon, and follow through with a wave of investigations or subpoenas.
Back in the day, defaulters were banned from Jonathan’s, and brokers unable to pay were labeled a “lame duck” — being expelled from the coffeehouse meant a significant loss of business for a broker. The community today needs to hold as many individuals accountable as possible, and be labeled ‘lame ducks’ so that they can’t replicate their activity again.
The crypto community as a whole needs to do what the London Stock Exchange did; rather than relying on public regulation to enforce contracts, brokers consciously found a way to solve this dilemma by creating and enforcing a system of private rules. For many years the London Stock Exchange had no formal constitution and it was not until 1812 when they issued their first rulebook. In 1877 even the government declared that the Stock Exchange’s rules “had been salutary to the interests of the public” and that the Exchange acted “uprightly, honestly, and with a desire to do justice”.
In general, all of the regulation aimed at putting a stop to derivatives trading — at various times throughout the 1600s, selling short was banned in Amsterdam, England in 1697 was to prevent forward trades — especially short sales –legislation had no impact on time trades and little impact on the trading practices of either “sworn brokers” or “jobbers”. Sir John Barnard’s Act in 1734 exhibits a similar pattern. Sir John Barnard’s Act was the most significant regulation to affect trading in that it prohibited all derivative contracts and provided stiff penalties for engaging in them.
As mentioned before, all were ineffective at eliminating time trades and had little effect on the behaviour of market participants. Derivative trades in England and Amsterdam for the second half of the 17th and the first half of the 18th century (before Barnard’s Act) were viewed as gambling contracts under the law and thus were unenforceable in court.
The ‘community’ itself resolved to solve problems despite contracts being unenforceable by law as noted above — brokers had developed genuine ‘rules of conduct’ by the early 1700s to help gain trust of the public. An event we are seeing in the ICO space developing right now.
Adam Smith (1766) makes similar observations on the role of reputation in undermining the government’s prohibition of time trades: “Persons who game must keep their credit, else no body will deal with them. It is quite the same in stock-jobbing.”
To conclude, what becomes apparent by looking at the history of derivatives markets is that bodies developed their own set of rules and regulations, ahead of government intervention, to combat the problems surrounding fraud and disingenuous activity. Bad actors were kicked out, sometimes literally, and no one would do business with them.
When government intervention aimed at putting a stop to what was basically commercial reality appeared, the rules, regulations and edicts were largely ignored by the public and activity continued, at times even when it was illegal to do so. Despite not having legal recourse, a self policing and self regulating environment developed. There is little reason to think that even if ICOs or cryptocurrencies are banned, activity will stop completely.
After all — “The game does not change and neither does human nature.”