Scamming with the Phrase "Peer-to-Peer"

These days, we see the term “peer-to-peer” describing all sorts of new businesses.  There’s P2P lending, where people bypass banks and lend money to each other.  P2P carsharing, P2P livery service, P2P lodging. Real estate agents should advertise as facilitating P2P house trading.  When people buy or sell houses, they’re almost always transacting with other customers, not businesses or professionals, so it seems totally P2P to me.

I ask, “What qualifies as peer-to-peer?” because I see CurrencyFair and TransferWise using the term to imply that you can exchange money directly with another customer instead of going through a bank.  The thing is, that’s not at all how it works at CurrencyFair despite their early marketing materials depicting customers transacting with other customers.  CurrencyFair have come clean and admitted how it really works in the fine print on their site, but they continue to use the term “peer-to-peer”.  I’m pretty sure TransferWise also doesn’t match customer orders only with customer orders and I’m about to begin investigating to check if they’re profiting off of imbalances in customer order flow, but my speculation as to what they might be doing is for another post.

Consider a used car dealership.  Used car dealers could argue that they’re a peer-to-peer business.  As if they’re just providing a service of matching buyers with sellers.  But I’d say that they’re not P2P because the buyer doesn’t know what price the seller received.  Neither the buyer nor seller can tell the true cost of the transaction.  The dealer’s profit comes from holding inventory and offering different prices to buyers and sellers.  With real estate, on the other hand, buyers are truly matched with sellers while the brokers take a 6% commission with all the compensation out in the open for all to see.

CurrencyFair operates a platform on which parties (not just customers, as we will see) can exchange currencies and pay 0.15% in commission.  However, because it’s unlikely that customer orders come in equal and opposite quantities at the same time, CurrencyFair operates its own currency dealing business that will always offer to trade at 0.5% worse than the going rate for currency.  So most customers actually trade with “the house” and pay on the order of 0.5%.  I asked CurrencyFair if I can become a participant dealer and improve pricing by offering money at 0.4% worse than the going rate at all times, but they wouldn’t let me.  They don’t even offer the ability to place an order pegged to the mid-market rate to trade with any customer that comes along.  Because exchange rates move so fast, it’s unlikely that two customers will trade with each other unless they’re allowed to enter orders that track mid-market.  If I place an order at mid-market, the market will move and CurrencyFair’s dealer will trade with my now stale bad price before a customer gets to benefit from it.  That’s about as peer-to-peer as a car dealership where a seller just might happen to run into a buyer in the parking lot and negotiate a direct deal.

Is there legal precedent for such a business?  Stock exchanges used to be owned by their members.  The New York Stock Exchange was a venue for brokers and dealers to trade with each other and would charge a commission for each trade.  But because customer orders to buy and sell stock (brought to the exchange by brokers) don’t come in equal and opposite quantities at the same time, the dealers (who owned the exchange) would trade with the orders at slightly unfavorable prices.  That’s a lot like how CurrencyFair takes a 0.15% commission for each transaction and at the same time the people who own CurrencyFair always get to trade at prices in their favor.  The difference is that the way the NYSE worked was fairly widely known.  Customers didn’t like overpaying for transactions, but knew that feeding the dealers was just part of doing business.  It didn’t feel as much like a deceptive scam.

I can summarize it like this:

  •  Car dealers don’t tell you black book prices.  Yeah, you’ve never even heard of it, right?!
  • CurrencyFair doesn’t tell you the fair price for your transaction, which would let you see how much you’re losing.
  • TransferWise shows you a fair price, but probably not the fair price at the time they decide that your transfer will definitely be executed.

Thoughts on the Knightmare

The Knightmare is what we call an event during which Knight Capital, at the time a large publicly traded electronic trading group, lost $460 million in about 45 minutes.  If the error had gone undetected longer, Knight would have gone bankrupt and broken the market by not paying for its trades.  That such a thing could happen illustrates a problem with how our markets work.

When you or I place an order to buy stock, our brokerage firm first checks how much money is in our account and how many other outstanding trade orders we have that could reduce our available funds.  The brokerage firm only sends the order to an exchange after confirming that we have sufficient funds.

We cannot trade directly on the New York Stock Exchange because there would be nobody to guarantee that we can actually pay for the trade.  The stock exchange has members, known as dealers or brokers, who pay expensive membership fees to be able to trade directly.  Brokers are the ones who bring customer orders (such as yours or mine) to be filled.  Dealers are there to take the other side of our order because there may not be another customer who wants the exact opposite trade at the same moment.  Both brokers and dealers have to prove that they have adequate money and risk management controls in place to make their trades without the exchange checking their ability to trade all the time.  Part of this process involves going through a “clearing firm”, usually a very large financial institution, who holds their money and securities.  The clearing firm checks their financial status at the end of every day.  The clearing firm also guarantees that all the trades will be paid for.  To avoid the possibility of a small dealer with a few million dollars buying billions of dollars of stock, the clearing firm will monitor the dealer’s finances throughout the day.  Still, the process is a little backwards, with the trade being executed first, then the ability to pay for it being checked.

Knight Capital had computers sending automated orders to the exchanges with no systems verifying how much money it would cost to fill all of them and comparing it to the available funds of the firm.  It seems a little absurd that they are in charge of regulating themselves.  It seems a little like asking a child to decide how many cookies to eat.  Part of the reason trading works this way is that given the volume of orders submitted to exchanges daily, it is technologically impossible to run each one through a validation process.  But maybe requiring exchanges to clear all orders (verify adequate funds) would do two things.  First, it would slow down the high frequency electronic trading that’s creating an overload of data and risks of events such as the Knightmare.  Second, it would lower the barrier for customers to bypass brokers and trade directly on the exchange.

Tradesports / Intrade and various online currency trading sites already handle both exchange and clearing functions at the same time.  To do so, they developed some amazing computer technology such as the LMAX Disruptor http://martinfowler.com/articles/lmax.html  I’d like to see that approach applied to stock trading.  But it’s hopelessly complex from a legal standpoint.  Ideally, regulators would require all exchanges to clear all their orders.  But that’s unlikely because it’s a huge change and many in the financial industry would lobby against it.  A company could attempt to offer a “fair” exchange with equal access for all retail and professional traders, but it would have to somehow allow itself to be detached from the national market and exempt from Reg. NMS (the national market system).

I think a requirement for all orders to pass through a clearing stage is still a better solution to “high frequency trading” problems than a financial transaction tax.  If the tax can overcome lobbying and aversion to change, a requirement that directly lowers risk and benefits retail traders should be more palatable to regulators and financial market participants.