During a recent financial war game exercise at the Pentagon, I recommended that the Securities and Exchange Commission (SEC) and New York Stock Exchange (NYSE) buy a warehouse in New York. They would equip it with copper wire landline phones, hand-held battery powered calculators and other pre-internet equipment.
This facility would serve as a non-digital stock exchange with trading posts.
The SEC would assign 30 major stocks to each of the 20 largest broker-dealers, who would be designated specialists in those stocks. This would provide market making on the 600 largest stocks, covering over 90% of all trading on a typical day.
Orders would be phoned in on the hardwired analogue phone system and put up for bids and offers by the specialists to a crowd of live brokers. This is exactly how stocks traded until recently.
The SEC would ban computerised and algorithmic trading as nonessential. Only real investor interest would show up in this non-digital venue.
In the event of a shutdown of the NYSE by digital attack, the authorities would activate the non-digital exchange.
The US would let China and Russia know this facility existed as a deterrent to a digital attack in the first place. If America’s rivals knew it had a robust non-digital ‘Plan B’, they might not bother to conduct a digital attack in the first place.
How the ‘force multiplier’ will cause mass destruction
Financial warfare attacks vary in their degree of sophistication and impact.
At the low end of the spectrum is a distributed denial of service, DDoS, attack. This is when a hacker floods a target server with an overwhelming volume of message traffic. Either the server shuts down or legitimate users cannot gain access. In such attacks, the target is not actually penetrated, but the message traffic jam disables it.
The next level of sophistication is a cyberhack in which the target, say a bank account record file or a stock exchange order system, is actually penetrated. Once inside, the attacking cyberbrigade can either steal information, shut down the system or plant sleeper attack viruses that they can activate later.
In 2010, the FBI and US Department of Homeland Security located such an attack virus that Russian security services planted inside the Nasdaq stock market system.
You have probably noticed that unexplained stock market outages and flash crashes are happening with increasing frequency. Some of these events may be self-inflicted damage by the exchanges themselves in the course of software upgrades, but others are highly suspicious. Exchange officials have never disclosed the exact causes.
Here is a recently revealed classified map showing cyberattacks by the Chinese government against US interests. Each dot represents an attack. Notice the concentration of attacks against technology targets in San Francisco, financial targets in New York and military and intelligence targets in the Washington-Virginia area.
The most dangerous attacks of all are those in which the enemy penetrates a bank or stock exchange not to disable it or steal information but to turn it into an enemy drone.
Attackers can use such a market drone for maximum market disruption and the mass destruction of Australians’ wealth — including your stocks and savings.
In this scenario, an attacker could penetrate the order entry system of a major stock exchange such as the Australian Securities Exchange (ASX), or one of the order matching dark pools operated by major investment banks, such as the SIGMA X system that Goldman Sachs controls.
Once inside the order entry system, the attacker would place large sell orders on highly liquid stocks such as BHP Billiton Ltd [ASX:BHP] or Telstra Corporation Ltd [ASX:TLS].
Other system participants would then automatically match these orders in the mistaken belief that they were real trades. The sell orders would keep flooding the market until eventually other participants lowered their bids and began to deflect the selling pressure to other exchanges.
The cyberbrigade would launch an attack of this type on a day when the market was already down by 3% or more, like the one we saw on Monday of last week.
Military strategists call that a ‘force multiplier’. It’s how you use external events to increase the power of an attack you have planned.
The result could be a market decline of 20% or more in a single day, comparable to the stock market crash of October 1987 or the crash of 1929.
You would not have to trade anything or be in the market during the attack; it would wipe you out based on the market decline even if you did nothing.
There is no stopping a first strike
Another type of highly malicious attack is to penetrate the account records system of a major bank and then systematically erase account balances in customers’ deposit accounts and super funds. If the attack extended to backup databases, you or other customers might have no way of proving you ever owned the deleted accounts.
Some analysts respond to such scenarios by saying that Australia and the US have cyberwarfare attack capabilities that are just as effective as those of our enemies. If Iran, China or Russia ever launched a cyberfinancial attack, we could retaliate.
The threat of retaliation, they claim, would act as a deterrent and prevent the enemy attack in the first place. This is similar to the doctrine of ‘mutually assured destruction’, or MAD, that prevented nuclear conflict between the US and Russia during the Cold War.
This analysis is highly flawed and gives false comfort.
MAD worked during the Cold War because both sides wanted to avoid existential losses. In financial warfare, the losses may be existential for the US or Australia, but this is not true for Russia, China and Iran.
Because their financial markets are far less developed, their exchanges could crumble and it would have little impact on their overall economy or national security.
US and European investors own many stocks in Russia and China, so any damage would come back to haunt Western interests.
The technological warfare capabilities may be symmetric, but the potential damage is asymmetric. That means the deterrent effect on China and Russia is low. There is essentially nothing stopping Russia, Iran or China from launching a ‘first strike’ financial warfare attack if it serves some other national strategic purpose.
What can you do to preserve wealth when these cyberfinancial wars break out?
The key is to have some portion of your total assets invested in non-digital assets that cannot be hacked, wiped out or disrupted in financial warfare.
Such assets include gold, silver, land, fine art and the kind of private equity that does not rely on electronic exchange trading for liquidity.
Tim Dohrmann has analysed the investment opportunities in the fine art world. Tim edits my investment advisory service, Strategic Intelligence. In our latest issue, Tim made several fine art recommendations — and some will cost you less than $1,000 to get started.
As an investor, you don’t just have enough to be concerned about factors like inflation, deflation, central bank policy and the overall state of the economy. Now you have another major threat looming — financial warfare, enabled by cyberattacks and force multipliers.
The time to take defensive action by acquiring some non-digital assets is now.
Strategist, Strategic Intelligence
James G. Rickards is the strategist for Strategic Intelligence, the newest newsletter from Port Phillip Publishing. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.