The original version of this article was published in the Fall 2022 issue of Bitcoin Magazine (“How Markets Mature Over Time”)
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Bitcoin’s inherently anti-establishment philosophy means greater regulation is unlikely to be welcomed. Yet, the stunning collapse of FTX and allegations of fraud against cherubic founder Sam Bankman-Fried underscore why greater levels of regulation are needed.
Lessons from the past, however, may assuage the crypto community’s trepidations over government intervention. The history of equity markets reveal how effective government regulation can actually facilitate widespread adoption by standardizing market conditions, preventing manipulation, and protecting the average investor.
For while equity markets are now a staple of modern finance, like bitcoin, the stock market has endured long periods of unfettered speculation and fraudulent activity. The transition from “Wild West” to key financial institutions began with disruptive technology and ended with much-needed regulation.
THE DEVELOPMENT AND REGULATION OF EQUITY MARKETS
To draw lessons on regulation and the path forward for Bitcoin, this article focuses on the development and regulation of equity markets through three prisms:
- Speculation and “The Bucket Shop Problem.”.
Throughout history, technologies have unlocked new capabilities, enhanced existing systems (faster, simpler, etc.), and improved the overall accuracy and quality of information.
For example, before a German goldsmith named Johannes Gutenberg invented his printing press in the 15th century, scribes manually reproduced text by hand. Besides the obvious inefficiencies, this system was also problematic because scribes intentionally omitted or altered sections of text they copied to influence readers’ interpretation.
Thus, increased accuracy was an underappreciated aspect of Gutenberg’s press. Printed formulas and tables allowed those in statistical fields like science and mathematics to trust the accuracy of datasets and spend less time verifying their fidelity and more time generating new insights.
In the early 1600s, Sir Francis Bacon, father of the scientific method, considered the printing press one of the three most important inventions ever.
Four centuries later, Edward Callahan’s ticker machine had a similarly profound impact on financial markets. Before these devices disseminated stock prices across America via telegraph cables, only those physically near the New York Stock Exchange (NYSE) were privy to real-time prices. Major publications like the Wall Street Journal did not publish closing prices until 1868, and even those could not be trusted:
“There were no official closing quotations. The newspapers would publish such late quotations as some broker, who remained late, saw fit to furnish.”
Therefore, in the pre-ticker era, a simple way to “beat the market” was through speed. D.H. Craig of Boston, for example, implemented a carrier pigeon system for receiving news from Europe before other investors. Craig boarded European steamships arriving in Halifax to obtain the latest news, tied summaries to his carrier pigeons and sent them home to his Boston colleagues. Investors that subscribed to Craig’s services gained access to early information.
Then, in 1867, Callahan’s ticker machine changed everything.
Tickers democratized access to market data. Using telegraph cables, the ticker distributed real-time prices across America. Proximity to the NYSE was no longer a barrier to accessing market data. By 1905, 23,000 offices paid for ticker services in the United States.
Like Gutenberg’s printing press, tickers standardized market information. Thousands of brokerage firms received the same data, at the same time, from the same source. Yet, as with any innovation, there were downsides.
Speculation and “Tickeritis”
The ticker poured lighter fluid on speculative fires. A 1904 Medical Times article described how speculators losing money develop “tickeritis”:
“[the losing speculator develops an] attack of ‘tickeritis.’ I have long held the theory that the constant ticking of the instruments in a broker’s office throws the majority of traders into a state of self-hypnosis, in which they become automatons, invariably with unerring instinct doing the wrong thing…
Men in this condition seem incapable of independent thought or action; their judgment and self–reliance are gone, and their state is deplorable indeed. When in this shape often small losses have an undue effect; men have been known to commit suicide grieving over losses that in other lines of work would have seemed trifling.”
Like mobile trading apps today, speculators incessantly checked the ticker tape like addicts. Wall Street restaurants owning ticker and quotation boards advertised that diners could “follow the market while enjoying a delicious lunch.”
Democratization without Regulation
The ticker democratized access to financial markets geographically and leveled the competitive landscape by providing standardized data to all investors. Consequently, public interest in markets rose and many new investors entered the market. However, there were effectively no laws or regulations in place to protect this class of new, inexperienced investors from being exploited.
In this era of financial history, insider trading was not even illegal.
For example, in October 1904, Lillooet Gold Dredging Company shareholders learned tens of thousands of dollars were unaccounted for. Simultaneously, the company’s stenographer, Mrs. M. V. Hamilton, had recently flaunted cash and spent recklessly. Yet, Mrs. Hamilton had not stolen the money. However, she did know that it was missing before shareholders because she had access to confidential corporate documents. Using this knowledge, Hamilton shorted her company’s stock and profited greatly when news of the missing funds broke and Lillooet Gold Dredging stock plummeted. Mrs. Hamilton kept her profits and was not charged with any wrongdoing. No one considered her actions questionable.
Therefore, true market manipulators like Daniel Drew and Jay Gould were largely free to exploit the inexperienced group of “lambs” entering the market.
The above cartoon from 1881 depicts robber barons using ticker tape to suspend a razor blade over eager speculators grasping at stock certificates (“this indicator rises and falls with stocks”). Behind them, a “Lamb’s Brigade” of retail speculators enter the NYSE. Fittingly, the cartoon is titled “Cut-Throat Business in Wall Street – How the Inexperienced Lose their Heads”.
Similarly, an 1873 investing book stated that “sooner or later, the money of the smaller tribe of speculators finds its way into the pockets of these financial giants”. The author advised young speculators to just gift robber barons their money since they’d get control of it through market manipulation regardless:
“Before you venture on this perilous step, go to Cornele [Vanderbilt] or Jay Gould, and make them a free gift of all the money you are willing to risk, (for into their strong boxes [safe] it will come at last,) and thus you will be saved a world of wrong and trouble…”
This environment underscored an important lesson; democratization without at least basic regulation is perilous for the average investor.
“THE BUCKET SHOP PROBLEM”
Callahan’s ticker machine also birthed a new industry; bucket shops.
The term “bucket shop” originated in 19th-century England, where poor children emptied beer kegs discarded by pubs and resold them in abandoned stores. In markets, this term referenced “shops” where customers gambled on the direction of stock prices. Bucket shops often looked like traditional brokerage offices with their ticker machines and quotation boards flashing real-time prices. However, customers’ “trades” were not real. A bucket shop patron buying ABC Railroad shares never actually owned ABC Railroad stock, they merely speculated on the movement of ABC Railroad’s share price.
Yet, for average investors, bucket shops were one of the only avenues for accessing financial markets. Exchanges like the NYSE had prohibitively high margin requirements and minimum trade sizes that prevented most citizens from investing.
Anybody could enter a bucket shop and wager on the stock market. Although technically separated from the real stock market, bucket shop customers still participated in markets tangentially. In 1917, Charles H. Taylor wrote that bucket shops were “where the common people could speculate”.
The New York Times reported in 1889 that 5,000 bucket shops across America handled roughly 1 million trades daily; 4-5x the average daily NYSE transactions.
Since customers bet on the direction of stock prices, another key difference between bucket shops and stock exchanges was the relationship between customer and dealer. Traditional stock exchange brokers earned commissions by acting as a fiduciary agent for their customers (i.e., placing trades, etc.).
Conversely, bucket shop proprietors and their speculative patrons were adversaries in a zero-sum game. Bucket shops profited when their customers made bad trades. If customers made profitable trades, bucket shops lost out.
Due to this zero-sum dynamic, bucket shops developed tactics for manipulating stock prices at customers’ expense. The strategy most damaging to financial markets was “wash sales”.
For instance, say Bucket Shop Enterprises noticed every customer was betting that Western Union’s stock would rise. If customers were right, the bucket shop would have to pay out a lot of cash. Their solution? The wash sale.
Bucket Shop Enterprises places a large sell order for Western Union on the NYSE at a price far below Western Union’s current price. This “washes down” Western Union’s stock price, and when their low sell order quotation came through the bucket shop via ticker tape, Bucket Shop Enterprises closes out their customers’ bullish bets as a loss since the stock declined.
This nefarious tactic established a link between the theoretically “fictitious” activity in bucket shops and activity on real stock exchanges. Thus, the traditional stock market suffered from manipulation and shady activity stemming from bucket shops. This negatively impacted stocks, as wash sales depressed prices. The New York Times wrote in 1889:
“Among people who trade in stocks there is practically a universal disposition to buy… They are always bulls; they are always buying. The necessary result is that the bucket shop proprietors are always upon the bear side… [they] are simply short so much, they are gambling for a fall in prices. With such gigantic interests at stake, the bucket shops are more largely than anybody else dependent upon ruling the stock exchange market…
When the bucket shop short interest has grown so large as to require a raid upon the market for the purpose of working down quotations and wiping out customers, the raid is made, the quotations are worked down, the wiping out process goes gayly on…
[thus] it is readily understood how the Stock Exchange market, and investors generally have suffered. Every time the stock market has shown a disposition toward strength the bucket shop contingent has hammered it.”
As bucket shops became more influential and fueled gambling behavior, government officials and stock exchanges waged war on the bucket shops. Stock exchanges cut off bucket shops’ access to real-time prices by removing their telegraph cables from the exchange. States and the federal government enacted bucket shop bans.
Finally, the NYSE celebrated the death of bucket shops in 1915. These “gambling dens” were eradicated from America’s financial system. However, bucket shops highlighted how speculation and manipulations in a seemingly unconnected market (bucket shops) could materially impact more institutionalized markets (stock exchanges).
Officials celebrated the downfall of bucket shops, but their demise created a new problem; the mass of speculators newly interested in investing were left without a way to access markets. At this point, stock exchanges finally realized this class of retail investors was a source of new business and lowered or removed the prohibitively high trading restrictions.
This seismic shift in markets had two profound consequences. First, retail investors participated in traditional equity markets for the first time at scale. Second, the retail investors’ primarily bullish trades that previously went to bucket shops — and led to bucket shops forcing down prices on stock exchanges via wash sales — were now placed through the stock exchange directly.
However, there were still no real regulations protecting retail investors from manipulation and fraud.
The 1929 Crash, Sentiment Shifts, and Calls for Regulation
The 1929 crash was a unique episode in American financial history because of the high levels of retail participation. In addition to the reasons already covered (ticker technology, NYSE lowering restrictions, etc.), the Liberty Loan drives of World War I introduced millions of American households to the concept of financial markets and investing.
Coupled with an economic boom now known as the Roaring Twenties, and the ubiquity of margin trading, America’s retail investor was intimately involved with the 1920s bull market . However, there were still no effective regulations protecting these retail investors. Thus, when the 1929 crash wiped out America’s economy and retail investor crowd, calls for regulation and greater oversight were deafening.
The crash and Great Depression was a watershed moment in the development of stock market regulation. The average investor had fended for himself/herself against the market rigging and fraud executed by large “trust pools” and manipulators. In October 1936, The Economist wrote:
“There were, indeed, very grave abuses in the security markets in the years before the depression…
The banks not only invested their own funds in securities, they not only poured money into the markets for the use of speculators, but, through their ‘security affiliates’, they took the lead in peddling securities, often of doubtful merits, up and down the country.
there was far more profit being made by ‘those in the know’ at the expense of the innocent investor than could be reconciled with a healthy state of the markets… all forms and varieties of rigging the market were rampant.”
After the Dow Jones Industrial Average fell 89% from its 1929 peak through 1932, the American public angrily demanded market regulation. Newspapers described “a nation-wide spirit of anger which clamored for reform of the abuses of the system which had permitted the depression to happen. Those abuses centered in the securities exchanges of the country”.
Stories like that of Albert H. Wiggin, head of Chase Bank, exacerbated public outrage and led to the regulations enacted in 1933 and 1934 that would mark a new era of market oversight. In 1929, Albert Wiggin had shorted 40,000 shares of Chase Bank stock, despite being head of the institution, and profited $4 million while shareholders suffered massive losses.
Impact of the 1933 Securities Act and 1934 Securities Exchange Act
The public outrage and federal investigations of bad actors in financial services culminated in two pivotal pieces of legislation under President Roosevelt’s “New Deal”; The Securities Act (1933) and Securities Exchange Act (1934).
- 1933 Securities Act: Required all securities to be registered with the Securities Exchange Commission. Parties registering a security were also liable for omissions of fact and/or misleading statements. Companies had to make mandatory disclosures and provide key business information via prospectuses so investors could make informed investment decisions.
- 1934 Securities Exchange Act: Established a federal agency (the SEC) for enforcing securities regulations in the secondary market to prevent practices like insider trading, manipulation, fraud, and regulate the exchanges themselves. The SEC was charged with overseeing the enforcement of securities laws.
Upon signing the 1933 Securities Act, President Roosevelt said:
“This Bill requires the publicity necessary for sound investment. It is, of course, no insurance against errors of judgment. That is the function of no Government. It does give assurance, however, that, within the limit of its powers, the Federal Government will insist upon knowledge of the facts on which alone judgment can be based.
The new law will also safeguard against the abuses of high-pressure salesmanship in security flotations. It will require full disclosure of all the private interests on the part of those who seek to sell securities to the public.
The Act is thus intended to correct some of the evils which have been so glaringly revealed in the private exploitation of the public’s money. This law and its effective administration are steps in a program to restore some old-fashioned standards of rectitude. Without such an ethical foundation, economic well-being cannot be achieved.”
Previously, retail investors were at a significant disadvantage to their wealthy investor peers as they had no connections or influence on Wall Street and were thus “out of the know”. As The Economist stated in 1936:
“Prohibition is only one of the weapons placed in the hands of the S.E.C. The other is Publicity. To secure registration of its securities on an exchange, a corporation must file with the S.E.C. a great volume of information about its finances, all of which is published… It is pure gain that the searchlight has been turned on the activities of directors as well as on those of the corporations they control.”
The impact of this legislation on financial markets highlighted just how much fraudulent activity existed in the pre-regulation era.
For example, the chart below shows that IPOs on non-NYSE exchanges had an average five5-year return of -52.6% before the 1933 Securities Act. After the Securities Act brought greater scrutiny and liability to companies going public, however, these average returns miraculously improved. Why? Bad actors that previously floated fraudulent and shady companies “disappeared” as they faced serious regulatory consequences under the new Securities Act!
Thus, the average five-year return for IPOs on non-NYSE exchanges rose to +5.7% after the Securities Act.7
THE LESSONS FOR BITCOIN MOVING FORWARD
The development and regulation of equity markets offers direct parallels and lessons for the Bitcoin community today.
Bitcoin’s Bucket Shop Problem
First, ardent Bitcoin supporters would likely agree that there are rampant levels of manipulation and fraud in the broader cryptocurrencies and digital assets landscape. Bitcoin, however, should be insulated from these nefarious activities, right?
Unfortunately, Bitcoin is undeniably impacted by the bad practices elsewhere in the crypto and digital asset ecosystem because bad actors frequently use BTC at some point in their schemes (i.e., as collateral, reserves, etc.). For example, when the algorithmic stablecoin TerraUSD unraveled in May 2022, bitcoin suffered because the Luna Foundation Guard set up by Terra’s founder dumped $3.5 billion worth of bitcoin on the market in attempts to prop up TerraUSD’s price. Although Bitcoin was not involved in the issues that led to TerraUSD’s unraveling, it was still negatively affected by this speculative episode. This is the burden bitcoin bears by being the largest cryptocurrency.
During the bucket shop era, stock exchanges learned that despite their best efforts, theoretically fictitious trades in seedy bucket shops had real consequences. Similarly, Bitcoin is still subject to the manipulative and fraudulent activity perpetrated by bad actors in other areas of the digital asset landscape.
Like stock exchanges in the early 20th century, Bitcoin supporters should cautiously welcome some government regulation in crypto and digital assets because it should help prevent bitcoin’s price being affected by bad practices elsewhere in the ecosystem.
The precedent for this is found in average IPO returns before and after regulations imposed by the 1933 Securities Act were established. When there was little consequence to floating shady companies and frauds on the stock exchange, bad actors did not hesitate, and the average investor suffered. Yet, after the Securities Act, the general quality of companies going public increased dramatically because of the disclosure requirements and personal liability of parties involved.
Bitcoin is currently in the “democratization without regulation” phase of development, which history has shown to be perilous for retail investors. To ensure the average investor can feel confident about not being exploited, the basic levels of government regulation that exist for other asset classes are needed to protect investors and facilitate broader adoption.
Regulation might be a taboo word for many Bitcoin proponents but accepting some regulation may fuel the growth of Bitcoin over time.
2 Francis Eames, The New York Stock Exchange, (1894)
6 “Security Markets The New Deal: An Analysis and Appraisal. Economist, 3 Oct. 1936, www.link.gale.com/apps/doc/GP4100641953/ECON?u=econstore&sid=bookmark-eCON&econStoreUser=true&xid=6f8d17c2
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