FIS’ David Lewis looks to the stars to show how the recent Perseverance rover landing on Mars should inspire a desire to remove friction and achieve greater data velocity
The laws of physics dictate the behaviour and reactions to almost everything we know and understand about the world around us. Recent achievements scored by the human race using their knowledge of physics include landing roving vehicles on Mars, a planet some 210 million kilometres or seven months away by spacecraft, and of course the production and distribution of hundreds of millions of doses of a vaccine for a virus few had heard of even 18 months ago. However, one of the defining statements that caveats many of the laws of physics confirms that the law applies “in the absence of friction”.
Gravity, for example, will accelerate any matter towards the centre of the earth at 9.8 metres per second per second (m/s2); the speed of that object will increase by 9.8 metres per second, every second … if not for friction.
Eliminate friction, you get to go faster
The same applies for almost any situation, including financial markets. Blockchain is, effectively, the elimination of friction caused by the transmission of securities, replacing it with ledger entries instead of actual account movements. The electronification or dematerialisation of securities did the same for share and bond certificates many years ago, eliminating the need for physical delivery to effect settlement.
Cost is both a cause and a symptom of friction; costs create barriers to entry and unnecessary actions create costs. Therefore, it stands to reason that the removal of costs can also lower the barriers to entry. For example, the rise of budget airlines across the world brought some speculation that pricing power would shift from airports to airlines. Instead of having airlines compete for landing slots and pay ever increasing rates for space, the rise in airlines, passenger numbers and the diversion to smaller airfields might force the airport operators to have to pay airlines to bring passengers to them in order to defend the incomes from their retail and other services. As the barriers fell, more entrants joined the fray and the big airlines had to adapt to the lower cost scenarios. Could the same happen in financing?
The democratisation of finance
Transaction costs, like flight tickets, have fallen in the finance industry, right across the spectrum from fee-free investment funds and low or no-cost retail brokerages to the cloud delivery of lightweight securities finance systems that firms like FIS provide. This has led to the lowering of barriers to entry and, as some argue, the democratisation of finance. Nobody should be excluded from managing their own finances should they wish to. However, recent events that concerned shares in the high street retail outlet, GameStop (GME), can highlight issues or weaknesses in the system as it stands. Free trading and brokerage can indeed open the markets to many more participants and investors. Rational theory would suggest that the more participants, the better the marketplace in terms of efficiency, depth and price discovery. Rational theory, of course, relies on the balance of buyers and sellers, i.e. those willing to take a positive or a negative position. If the market is imbalanced, and there are more of one than the other, then the prices will respond until equilibrium is re-established.
What the GameStop frenzy has taught people, if they are open to that, is that a market can be pushed out of kilter by a disproportionately large single institutional player as easily as it can be by thousands acting together as one. Unfortunately, many of those individuals are also learning that “free” brokerage or trading is limited to the cost of entry to those markets but it does not apply to the consequences of the actions you take once inside. As the internet will attest, many fortunes were made over the few weeks that GameStop spent in the headlines, but just as many would have been ruined by the precipitous fall from the peak of around $347 to just under $45 at the time of writing.
Looking back a year or more, short interest in GameStop was at the maximum 100 percent utilisation as far back as March 2012, and repeatedly hitting that level many of the days since. Volumes moved as the price varied between $22 and $55, but rarely fell below 50 per cent. One year ago, the shares had fallen to under $4 apiece, highlighting the poor forward value investors had with regards to the future earnings of GameStop as a bricks-and-mortar provider in a socially distanced and internet-based world. Allegations of inappropriate actions are now flying of course, and changes may come as a result.
Adding friction harmed the market
Following the financial crisis of 2007 and the years that followed, the then chair of the US Securities and Exchange Commission (SEC), Christopher Cox, cited the temporary application of a short selling ban in the US as one of his biggest regrets and that he believed “on balance the commission would not do it again”. They went further following more analysis and indicated that the “costs appear to outweigh the benefits” as spreads widened, and trading costs spiralled. It became clear to the SEC then that additional friction through increased costs harmed the market, indicating that the reverse would also be true. As a result, it is hoped by many that there will not be any irrational responses to these recent events that may harm the future of the financial markets, their efficiency and their increasing accessibility to all investors.
Short selling is a fundamental requirement of a balanced market and the economic allocation of limited capital, helping show that record high stock markets do not necessarily mean prosperity. Lower frictional costs allow more entrants, which in turn create better markets through increased depth and liquidity. As with space travel, the lack of friction between Earth and Mars undoubtedly helped the latest probes reach their destinations and land on the red planet. Hopefully, they are just as capable of surviving the volatile environment once they have arrived.
