The Internet and Financial Market Structure

Financial markets provide for trade in information because money is just a means of scorekeeping, a way of tallying the relative purchasing power of individuals and organizations. It can be a physical tally such as a coin made from rare metals or a paper claim on a government or other reputable agent that is difficult to counterfeit. But records of relative purchasing power also can be stored digitally as strings of ones and zeros if the storage medium is secure. Information generally is costly to produce but not to reproduce. In fact, information is perhaps too easy to reproduce once it is revealed, it is difficult to exclude others from further use of information. When the value of information mainly is strategic, as often is the case in financial markets, information producers have incentive to protect their investment by holding their cards close to the vest. But doing so obstructs trade and undermines the social interest in informationally efficient markets. Financial intermediaries promote trade in financial markets by balancing the tension between self interest and collective interests in information. Financial intermediaries endure a similar tension in their dealings w ith one another. Competition among intermediaries traditionally was fueled by the human capital of key families and individuals Morgan, Rothschild, Goldman, etc. whose names still dominate the financial landscape. Primitive information technology led early financial intermediaries to form information networks by scattering human repositories for information as widely as possible. 1 Fair dealing over time within the network led to strong relationships bound by trust through which information moved about more freely than it would have otherwise. Reputations and relationships, the foundations for trust, likewise are composites of information but information that is not so easily disembodied from its originator you can't buy a reputation. Innovation flourished in the context of close relationships and powerful intermediaries that tempered competition and thereby protected easily copied ideas and products assuring at least a fair return on investment. The internet upsets this delicate balance. We may look back on the internet as having punctuated the evolution of financial market, but its effect will most likely be interpreted as different in degree not in kind from the effects of motorized transportation, the telegraph and telephone, low-cost computers, etc. The internet is just another technological advance along a path where human capital is being transformed and in some instances displaced by information technology that codifies what previously was embodied in human intermediaries. The tension between human capital and information technology, however, has profound consequences for the organization and management of intermediary firms. The small family partnerships that dominated early financial markets provided an environment in which human capital was nurtured and passed from one generation to the next. By contrast, the modern financial firm depends far more on financial capital to support the large-scale but low margin operations that remain when intermediary functions are codified.