Abstract

Unstandardized Settlement: Market Structure and the Limits to Arbitrage in the First Age of Financial Globalization

In the late 19th century financial world, paper share certificates did not move as fast as the pricing information about them. Most studies of financial globalization in the period between Germany’s adoption of the gold standard in 1871 and the outbreak of WWI in 1914 have focused on the integrative effects of telecommunications on financial markets. Telegraph and telephone networks allowed arbitrageurs to move capital around the world quickly, closing pricing gaps between securities that were listed on multiple exchanges. While this insight is correct on a long-term, macroeconomic level, it is also incomplete. This paper argues that settlement procedures—that is, the actual exchange of money for paper share certificates—imposed restraints on the effectiveness of telegraphically executed arbitrage. When arbitrageurs were forced to deliver paper shares at settlement, they had to work at the speed of steamships or the overland mail rather than at the speed of telecommunications. The delay imposed by transporting paper shares limited arbitrageurs in two ways. First, settlement risk, or the risk of not having enough paper shares to deliver at settlement and thus defaulting, restrained arbitrageurs from pursuing their optimal trading strategies until settlement had been successfully completed. Second, the delays involved with settlement procedures exacerbated the financial constraints arbitrage firms faced. Arbitrageurs were forced to deploy more capital than optimal to keep their position open until the shares were delivered and settlement was finished, thus eating into the amount of capital they had available to deploy in arbitrage operations elsewhere. Ultimately, the lack of standardized settlement procedures among different financial markets throughout the world imposed significant restraints on the ability of new technologies like the telegraph to overcome the problem of distance and usher in an age of financial globalization.