Are financial markets too fast?

Are financial markets too fast?

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[Music] financial markets operate at ever faster speeds critics say that opens up new possibilities for manipulation and prioritizes speed of execution above liquidity and quality so is the current structure of regulation in the u.s. up to the task welcome to the big question the monthly video series from Chicago Booth review I'm Hal Weitzman with me to discuss the issue is an expert panel Eric bhootish is a professor of
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economics at Chicago Booth he's an expert on designing all sorts of markets from the markets for MBA classes and concert tickets to financial exchanges his research proposing had a slow down financial markets won him several awards and started a conversation among policymakers and industry professionals across the u.s. sharon bowen was a commissioner at the US Commodity Futures Trading Commission the regulator for US futures markets from 2014 to 2017 prior to that she was acting chair of the
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Securities investor Protection corporation following decades spent as a corporate lawyer in New York she currently serves on the board of directors of intercontinental exchange and Steve Crutchfield is head of market structure at Chicago trading company and a member of the advisory board at the Chicago Board Options Exchange he was previously an executive vice president at IntercontinentalExchange and CEO of nice a yeren X to us options exchanges panel welcome to the big
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question Shambo let me start with you do US regulators have the the the expertise and the technology to regulate these very high frequency markets I believe we do we do have the resources and expertise but having said that I've been a bit credit of the fact that the CFTC has been woefully under for underfunded for years and if we had more money we could have better technology by both by administration's from both parts of parties that funded for four years
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which is a long time and with more money we could invest in more technology but we do have the expertise to oversee these markets okay Steve Crutchfield you're in the markets do you feel that they're well regulated certainly yeah and and I absolutely will defer to Sharon on the question of funding and resources one question that that we often wonder about is about the focus and is the focus of the regulate regulators correct when taking a look at these markets for example particularly when we talk about some of the issues of
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latency minimizing trading driven by very advanced technology okay so let's go back a second latency minimizing meaning the fastest possible speed of trading right right and and and there's some questions around whether the regulators are focused on addressing the issues around incentives that arise from that type of trading or whether they're more focused on traditionally in the case of the SEC markets where I spend a lot of my career looking at rules on a case by case basis securities markets are on the side absolutely equities equities options index options and other products ETFs very popular with
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investors much of the regulation seems to be looking at individual rules if they're submitted and filed by exchanges which may in isolation be appropriate rather than always looking at the entire market structure that's created as a result of these rules piling up over many years okay well Eric bhootish that leads neatly into your research about slowing down markets but let's not go there quite yet because I want to talk first about this question of capacity and the technology that's needed to regulate markets is it your sense that markets the markets are kind of too fast to regulate or is it
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possible to regulate so I want I want I won't quite take the beta and possible to regulate and I had defer to the Commissioner of course on on the funding question but what I will say this relates to my research a bit is that the markets are more difficult to regulate than they then they could be because of the importance of speed and because of markets are trading literally FET as fast as technological as technologically
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possible which then creates these these funny things in the in the if you're trying to surveil markets where you have to take special relativity into account to figure out that this thing in Chicago happened before or after this thing in New York and it's it's possible to do so but it's more are more difficult more complicated than could be the case that has more sort of the philosophy of how the markets are approached rather than the capacity which we talked about earlier a shower Brown part of the way that in the u.s.
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that this works is that the markets actually regulate themselves so to what extent do you know the regulator's that you were at the CFTC depend on the exchanges which are now on the board of or depend on these industry bodies to regulate themselves and does that self-regulation work I think it does it really is a good balance I think of resources and expertise at the same time I think most of the exchanges have great governance practices you know for example at the New York Stock Exchange
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we have a separate regulatory oversight committee that's separate from the membership committee that is responsible for doing the surveillance of our markets as regulators we'd never abdicate our authority obviously and but for the the routine registrations licensing market surveillance I think it is a good balance between the agencies and the SRO and that in that respect okay the self-regulatory organizations
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and so for someone who comes from the outside said how can financial markets possibly regulate themselves you think it works perfectly well well you have to also remember these are really competitive markets and so the likelihood that when the player is going to go out and gain the system that couldn't happen for very long these guys telling each other this well so yes okay and yeah I would certainly agree from from the enforcement standpoint from the surveillance standpoint I do think and also having seen at the New York Stock
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Exchange and other markets very good separation of sort of business decision making customer service sales and then a regulatory arm often there's a CRO we used to have at NY IC who reports up through a different channel to a different board to prevent those regards exactly however I think there are some questions about not the surveillance and enforcement but actually the rulemaking itself and to what extent are exchanges promulgating rules that that that do it exchanges are really expected ultimately to do which is this is language from the the Securities Exchange Act of 1934
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which enabled the securities markets as they currently exist talks about investor protection in the public interest and part of the problem is that exchange is although they're expected to do that and on a case-by-case basis the SEC for example will ensure that the rules at least don't do the opposite of that there's nonetheless the question about what are their what are their incentives what exchange is actually incentive to do and unfortunately in many cases what exchanges are incented to do is to find the market participants who are the most elastic in terms of price in terms of
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incentives in terms of what technological advancements they can make relative to trading on a particular exchange those are the moment parity and and they're generally not right but those those most elastic participants the ones who have the ability to move their volume elsewhere oh it's because of that competitive dynamic are very often large institutions and those large institutions may have found a way i I wouldn't I wouldn't use the phrase gain the system but but may have found a way to to really profit from from existing at the very bleeding edge that special
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relativity world that the professor was talking about and often incentivizing rewarding the firms that have found a way to exist at that level that can lead to consolidation that can create oligopolies that can reduce the number of market participants who are out there providing bids and offers for investors to trade with and ultimately that's the function of markets right is to encourage aggressive bids aggressive offers attractive prices that investors can look at and there on the retail brokerage website screen and click and trade and in providing incentives that
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that that create the best environment for those that small number of institutions that are willing to spend all that money to live in that world of special relativity does not always have the result of ultimately providing the best prices the best experiences for investors and that's something that working something you're not you're not suggesting that that regulators should be creating the products in the market no sir no sir certainly not absolutely I mean is there a question there about for example the high-frequency traders who now provide so much volume to the exchanges can the exchanges really regulate them as
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vigorously as they should be regulated given that there's such customers fool them a couple of things about the high-frequency traders yes the market structure has changed and we do have different people bringing a liquidity to the markets than was the case a few years ago so traditionally when the banks were our liquidity providers with the capital rules they're less likely to do so in periods of stress because the capital constraints but when you take a look at things like
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flash crafts for example you know I think people presuppose that it's the h of t guys who flee the market and that just hasn't been the case they tend to be there and the providing liquidity because banks can't do it because they're constrained by capital cause we find that with more liquidity in the market means tighter bit/s spreads which means the cost of Cheaper for investors now I'm not trying to advocate for one player versus the other in the market you know don't get me wrong but I do
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think that you know the market should really dictate sort of the products that are acceptable you know with caveat so there should be a market for those products what about this question of regulation there because what you're saying about is them bring liquidity to the market so we could accept that but just the idea of sort of day-to-day regulating these firms does it is it harder because there's such big customers of experience it's not harder because of it okay mm-hmm so I want to make a few a few related points so one is on the
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incentives on the incentives discussion that we've been having I think it's worth highlighting that competition among exchanges has worked extraordinarily well in some dimensions and poorly on other dimensions I think the dimension in which it's worked in the record extraordinarily well as trading fees the the feet of caught the fees are complex they you need a PhD in organic chemistry or something to navigate navigate trading fees but the average fee to trade a share of stock in
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the United States is tiny it's about 0.01 pennies per share traded once you work through all the complexity so if you go to StubHub and buy $100 concert ticket you're paying 20 bucks if you go to the New York Stock Exchange and buy a hundred-dollar share of stock you're paying 0.01 pennies of fee so that's a big difference the dimension in which exchange competition is a lot less fierce is the sale of colocation and proprietary data feeds so selling speedy
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access to exchanges most latency-sensitive customers those fees have gone up noticeably over time there's one debate between a high-frequency traders and the New York Stock Exchange in which thy frequency traders said this particular aspect of your fees has gone up 700 percent and the last decade or so that's because it's the way I think about it conceptually as exchanges have they faced really vigorous fierce competition on one piece of their market which is trading fees if I if this if I can save a hundredth of a penny I'll go here not
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here but they have market power over the sale of colocation and data only the New York Stock Exchange can sell fast access to the New York Stock Exchange now that dynamic then I think is a friction against market design innovation because if you think if you think about an exchanges incentive to adopt new market designs that reduce the importance of speed in today's markets that such an innovation is good for the market as a whole I would argue but it's
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the one piece of an exchanges business that's any good that gives exchanges market power which is the sale of proprietary fast connectivity to that exchange I think that that's a friction against innovation and then something regulators could do there would be short of mandating a reform to reform to market designs would be at least to proactively clarify that new marketing designs are allowed but even that's been a step too far for us regularly I think it depends on how you define the market I mean I think you're right speed cost
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money those are ways to make it much more efficient for people to do age of T and it costs money to do it but you agree it's definitely cheaper for the investor but not every market as is liquid and so you don't see the H of T in those illiquid market so don't think it necessarily stifles innovation you know the porkbelly market I don't think you're gonna see a lot of people little market yeah I know maybe maybe four but not every market is the
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standardized in the liquid so and that's it so you're not gonna get innovation in every market there and I think the objective by the way for from a market design perspective is how to realize the benefits of algorithmic right trading your computers are good at stuff computer them and they don't need a professor to be a professor to know that computers are good at processing lots of information but you would still agree that the market should the market should create that what do you mean by the market should create that what's the competition so I as opposed to as
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opposed to regulators I think I believe in free market competition I'm a University of Chicago yes I think markets me need good rules within which yes competition takes place and I think that's a critical point it goes back to a question that you raised earlier which is our regulators going to create the perfect market do we expect that of regulators no I don't think we expect it I don't think we want it the goal the regulator's to create the sandbox right within which everyone can play fairly according to the rules but I do think getting back to a point you made in a minute ago a challenge that we have
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right now is that the regulators are not necessarily not only they're not encouraging but in some cases we're seeing they may not be allowing the type of innovation that we're talking about so for example there was a proposal from the Chicago Stock Exchange to introduce a speed bump for liquidity takers so the idea is if a firm sends in order that's going to remove a liquidity from the book it's held up for a very de minimus period of time it was 350 microseconds and the proposal one one thousandth of the time it takes to blink I'm very fond of exactly so a very short period of time that proposal was suspended by a
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commissioner at the SEC unilaterally for an indefinite period and it's just kind of hanging out there right we're not sure if that'll ever be even given a chance to become part of the competitive landscape I would argue that many liquidity providers my firm included the biggest obstacle that we see to providing better liquidity and showing better prices for investors is this risk of sniping or pickoffs which is other advanced firms with very sophisticated technology are a microsecond or less than a microsecond faster than we are or another firm at reading
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some event that's publicly available on a price feed somewhere and will cause us or another market maker to incur a trade that is immediately regretted in to the extent that that happens market participants start to price that in and they trade less aggressively and the result as it goes counter to that influence just a question of manipulation is actually a question of how is the price the best price because of the way that the market works oh absolutely yeah and I'm and I'm not speaking about manipulation whatsoever but I'm talking about professional participants causing each other to lose
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money and the cost of that ultimately is worst prices for investors and getting back to the technology point and point of our competition to the extent that a small number of firms have invested huge resources in being able to operate in that environment or microseconds in nanoseconds matter those firms have an advantage now now one could respond with the Darwinian question right which is well they deserve to survive the problem is ultimately that goes counter to those words from the Securities Exchange Act of 1934 investor protection and the public interest in order to enter the
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market right now and provide better prices to investors a professional trading firm has to solve a massively expensive technology program you know tens of millions of dollars at a minimum that's basically the equivalent of a regulator turning to market participants and saying oh if you want to trade in the market and provide liquidity and better prices to investors every time you respond to a market tick you have to compute the first 1 billion digits of pi we could make that requirement but why would we it's well why why impose this massive technology burden on top of it
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and it's not about pricing or risk management which is ultimately what we want investors to be able to benefit from right so it's really relative in this sense that with speed bumps you know which I think will be allowed you're gonna find everyone else having speed bumps absolutely so if you make it whatever timeframe you do the New York Stock Exchange were to adopt a well designed speed bump I would be delighted I think that would be good let's see soon as we were talking with our overall talk is that we know what these speed
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bumps mean so that's a perfect segue into you to give to give us your platform you've written research that stood out trading so it's so my specific proposal and this is in research I've been conducting since 2010 or 2011 or so so my specific you can think of it as this very specific type of speed bump where time is treated as a discrete variable so time might be broken down into say milliseconds a thousandth of a second 23 million units
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of time per day and orders that reach the exchange in a particular millisecond are all processed in a batch process at the end of that millisecond using an option so most milliseconds most stocks nothing happens sometimes in a millisecond an investor shows up and wants to buy 500 shares if they ask or sell to and share zatt the bid in that case we get the option processes that request a trade almost exactly in the same way as the current market that the difference is if there's a burst of
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activity in a particular millisecond which to Steve's point a few moments ago is typically algorithmic traders responding to some price signal then processing that burst of activity in a batch using an auction ensures that competition is on price and not speed and it protects liquidity providers from being sniped at and trading at an adverse at an adverse price instead trading at a price that is a market consensus price based on an auction it's reengineering competition at the
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millisecond level but it seems to me that that's in fact creating the kinds of dark pools we were trying to get away from I mean I think we really want or transparent real-time trading markets there's no such thing as transparent in real time right because it takes time for information to travel even from you to me excuse me but it certainly takes time for information to travel from one do you think the regulator should decide when they look at the millisecond or with the right you can reduce any economic
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argument tell I'll let the market figure it out and well what's the optimal to give to the best argue is that you can use some combination of technology and just engineering facts to identify what's a unit of time at which markets cannot go faster than that unit of without creating relativity problems and that unit of time might be you know half a millisecond I've heard I've heard some exchanges argue that it you know even if
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we process trades once every hundred microseconds every hundred millionths of a second which isn't as fast that's still long enough to batch process requests to trade that arrive at roughly the same time in response to roughly the the same economic news I think part of it comes down to a question of priorities welfare participants so from from a regulatory standpoint we we don't allow generally speaking shares to be traded in increments of a single share they're called odd Lots there are special rules round out lots of course but generally you have to trade 100
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shares at a time or one options contract or one futures contract generally you have to trade in certain price increments options trade in increments of pennies and nickels and dimes shares generally in pennies you can go out and decimals in some circumstances futures often and quarters but for some reason we have this view that that on the time axis we should allow an arbitrary amount of compression even when there's no further benefit to provide it to investors but there's just a gaming opportunity generally created that's the question sure so it's something I absolutely agree so I think there's some level where just as we've said in the
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exact amount might not matter too much 303 or 50 microseconds maybe it's a millisecond but there's some level where additional time competition doesn't help investors one could probably demonstrate that it may hurt investors and it just causes market participants to just kind of snipe at each other ultimately resulting in in inferior prices just as we've done when we said you're gonna trade 100 shares at a time not 50 not 10 right and Shambo and you said there will be speed bumps in your opinion yeah I mean I think people will compete based
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on tonight I don't mean this in your view this sort of arms race will continue yeah I don't think it's there's a sort of a good race to be honest because I think it just makes it a little bit more artificial and just creates dark markets so I don't think it's it adds much in terms of efficiency you know an eyes irregularly would want a regulator to sit with that speed bump would be that's because nobody has tried my speed bump see well they're gonna be speed bumps of all sizes out there before you know it there's some there's a market design the
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Devils in the details yeah right so it especially and we'll see I mean if it were to create better prices you know that's it so you know the proof will be in the pudding in Isis but I think it just creates another opportunity for you know a dark pool to be out there okay so being that we just go off the train let's go away from these yes regulation transparent expecially somewhere we can't see where we can't see it okay I have to agree that the proof is in the pudding I'd love to see somebody try it right now at
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least on the SEC side of the markets the equities and equity derivatives markets it's impossible because this this day has been placed on on this one piece of rule filing I'd love to see somebody try it and and we'll see it's certainly possible that that the events will turn out differently but my expectation would be some degree of speed bump would provide sufficient protection liquidity providers that they would no longer need to pricing these adverse trades that yeah I know I've heard the phrase unwanted trades if you're making a market you have to worry about having a trade that you immediately regret and
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immediately measured in really immediately let me fast much faster than the blink of an eye a trade that you're trying to get out of the way out but someone else is a millionth of a second fastest night view and that and that profession on professional combat might seem like just effects its zero-sum trading among professionals but ultimately it becomes a tax on the rest of the market because it makes it harder for professionals to provide liquidity to real investors we've been for this is
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one very important issue that we've been focusing on I will say just just as sort of a note for the record there are other regulatory concerns aside from the question of speed and technology one of them that we spend a lot of time worrying about right now the most important issue nobody's ever heard of in my opinion is the way bank capital rules adversely treats cleared options positions so in many cases you can have a position with very defined risk in the capital that a bank affiliated clearing firm that houses professional options traders trades at the end of the day have to set aside for that position is
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much larger than the maximum amount of money that that position could really lose under any circumstances so that's another form of tax on professional market participants that it falls under the bank regulation rather than the CFTC and the SEC world but so there are other areas where continued education of regulators is another issue I wanted to ask you about which is the the separation between futures regulation and securities regulation which as you said Eric you know that this is somewhat arbitrary distinction nowadays somewhat
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presumably dates back to the days when pork bellies completely different from shares in manufacturing companies but nowadays the one market can ricochet into another does that make sense that division that you have in the US which i think is unique to the US I think the division definitely makes sense I mean our equities markets about capital-raising in a way for companies to finance operations in growth the futures markets been historically used for risk mitigation and price discovery
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so do you think they have if you have different purposes and and I haven't said that of course people do trait across asset classes across time zones across currencies and I think that's fine but I think having the two agencies I think they actually complement each other in some respects I think notwithstanding that the history of it if you just kind of see where we are if you look at Europe they're still grappling with growing their capital markets Union you know their companies
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basically rely on banks to lend the money to to fund their growth so it's different you know nature they're talking about lowering their standards to get more people a list I frankly think our capital markets are the envy of the world and so I think the system really really does work what was your view on that on this separation between securities and I actually agree with everything the commissioner said I will say though that there are sort of these muddled areas in the middle right so you look at as SP 500 index options there
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are securities options there are futures options that are basically the same thing the seamy can't list SP 500 futures options that that expire at the end of the excuse me of the third Friday of a month because SIBO has those listed on the s-e-c regulator world so so so it would be nice to have a regulatory structure where some of those middle areas sort of ended up cleanly on on one side or the other on the question of fragmentation though in confusion resulting from regulation that's almost a separate
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question from the ceased SEC and the CFTC we have just in the SEC regulated world I'm not sure now how many equity trading venues I know there are 15 options trading venues there's a lot of fragmentation right there and it would be nice to see some steps taken to help to encourage a better integration across these many many markets because I don't think there was another country on earth where there are 15 exchanges all trading the same thing okay on this on a distinction between securities regulation and futures regulation so I
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don't have a strong view it's never made sense to me but I did and I think the the the products that they're these gray area products that are not quite pure I think you're I think to the commissioners point right there's a there is a large economic difference between capital formation for corporations and futures contracts there are a lot of products that live in the vast gray area in between we're debating
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or discussing what it what happened in structured in volatility products there a couple weeks ago and the the XIV exchange-traded fund for example orchestrated no excuse me that's a product that that's not about capital formation for Apple computer or Microsoft but even recently I mean even the recent Treasury report on the financial markets concluded that the costs of merging the two agencies outweigh the benefit this discussion
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happens every year pretty much right the decision is the same as a bad idea I was telling more in theory if we could start from where that's a different question yeah okay but start from ways way back though right the old wouldn't start from here alright well talking about things that fall kind of in-between I must ask you about crypto currencies which are currently a regulatory blackhole hey should they be regulated if should the US make a bid to regulate them much of you well we have I
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actually don't think they're in a regulatory buy call you know we we at my for agency if Dean Bitcoin and the crypto currencies to be commodities and I think that's the right answer and I think that the CFTC and the SEC have been pretty proactive and making sure that the investing public is aware of a lot of the fuss advertising and the farce marketing of various schemes to invest in these crypto currencies I do think you know we don't regulate the
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cash markets and the spot markets and so there's some question as to whether there should be regulation there but I think the regulators are doing a good job of like taking notice being very aggressive a particularly retail side where they see retail investors getting harmed which is the right approach but at the same time not stifling possible innovation that could come from the blockchain technology or detail for example so I think it's I think they're taking a good cautious approach without
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stifling innovation at one point I'd add to that I agree with everything that Commissioner just said is if you think about the formation stories of futures markets and of stock markets that you teach your students whether MBAs or undergraduates and futures markets always talk about wheat contracts that a farmer who wants to hedge the future price of wheat and we take talking about teaching about stock market to talk about an entrepreneur who needs to raise capital and you go to the capital markets and you can raise capital for your venture for Bitcoin I haven't heard
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those kinds of stories yet that are the real economic uses of cryptocurrency aside from buying fake ideas and drugs on the dark web and I'm waiting I'm you know we always they were all waiting curious I like I think the computer science is cool yeah but I'm waiting to see I think well laying about the economics and I worried that a lot of the Trading's gambling yeah and that gonna be a lot of retail investors who lose a lot of it that's what we have to be really vigilant on the enforcement side well unfortunately on that note our time is up my thanks to our panel Eric
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Buda Sharon Bowen and Steve Crutchfield for more research analysis and commentary visit us online at review dot Chicago Booth edu and join us again next time for another big question goodbye [Music] you

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