Loopring Learning Series, Part 2: Prices are Exchange Rates
When we think of buying goods or services, we think of the price — the dollar cost. Similarly, when we think of trading financial assets, we measure their value in dollars, attaching a price to every security.
What’s interesting to note is that in FX markets, we do not refer to the ‘costs’ as a price, but as an exchange rate. If we want to trade USD for CAD, we ask for the exchange rate between the two, not the price, per se. We would say that the USD/CAD exchange rate (the value of 1 USD in terms of CAD), is 1.28; meaning the ‘price’ for 1 USD is 1.28 CAD.
If we take this logic and nomenclature to other securities markets, and even markets for goods and services, we see that ALL prices are in fact just exchange rates.
Buying a can of Coke for $2 is an exchange rate, and paying the mechanic $150 for fixing your car is an exchange rate. We price everything in dollars because it’s easier, and serves as a good unit of account — where we can tell the difference in the value of two things by assigning more or fewer dollars to it.
Easier in this sense means easier than bartering — trading goods for other goods and services. If our mechanic would take payment in cans of Coke, we could just give him 75 cans, worth $150. However, this would be burdensome because it is not very portable, and also, not divisible; what to do if the mechanic cost $151 — would we give him half a can of Coke? Exchanging is not easy between some types of goods.
More importantly, we don’t barter because it would rely on the assumption that our mechanic loves drinking soda, or can otherwise turn these cans into some good or service he has use for (by finding someone else who does love soda).
Thus, we use money — as an intermediate commodity — to solve this problem of needing to want what your trading partner is offering. This is called the double coincidence of wants problem. Money, or more precisely, currency, acts as a good medium of exchange between people that have different preferences. [Note: people have to want/believe in the currency for this to work…which only happens if they believe others want/believe in the currency, and so on.]
We are left with the fact that everything is indeed an exchange rate, but having one side of the exchange rate be a common currency (USD, let’s say) makes life easier. That’s why we invented currency to begin with! Trading got a lot easier for our ancestors when they started carrying around bags of shells (early money) vs herds of goats and other consumable goods.
Loopring recognizes that everything is an exchange rate, and has built its order structure to reflect that. The Uni-directional Order Model (UDOM), expresses all trade orders as requests to exchange. The order need not be ‘priced’ in USD, BTC, nor ETH; it can be any arbitrary token vs another token. The exchange rate is simply the amount of tokenA, vs the amount of tokenB.
If we can imagine representing a can of Coke and our mechanic’s labor by cryptographic tokens, we could express our Coke/Mechanic trade as 75 Coke coins for 1 Mechanic-hour coin.
Given that Loopring deals with blockchain-based assets, of which ownership can be transferred trivially (and irreversibly) to someone else, it allows for an economy where people can trade with each other across any imaginable set of pairs. You may be saying, however, this doesn’t solve the double coincidence of wants problem:
Making it easier to transfer assets over a blockchain doesn’t mean I can more easily find someone who wants the opposite of what I want — AKA can be my trading partner.
That is true. As far as I can tell, there are two ways to overcome the coincidence of wants problem; using a currency as an intermediate commodity, as already discussed, or, expanding your ‘circle’ of potential partners wide enough so that coincidences are not rare at all — there is always a mirror image to your trade.
In the past, it’s clear to see why using monies such as shells, silver or fiat currencies was the choice; you can only expand the universe of potential trading partners by so much. Imagine being in a bazaar 1100 years ago: you go to a flower merchant, and if he doesn’t want your clay statues as payment, you could try and find someone else in the market who may want your statues, and who would give you some chickens in return — which the flower merchant said he wants. Obviously this can get out of hand very quickly.
Even now with global telecommunication, it is still complicated to match such wide-ranging exchange desires, especially in a ratio (or, price) that satisfies each person. How many statues per flower per chicken, etc.?
This is one of Loopring’s most prominent advantages: it connects different orders in an order-ring so that each trader can ‘want what they want’, and offer their existing assets in exchange. Loopring protocol is the connective tissue between orders that can expand the universe large enough so that ‘coincidences’ don’t really exist. It is not merely expanding the universe by bringing more traders to the market (the traditional way liquidity is improved), it is actually multiplying the possible trades between traders. By mixing and matching orders, you can create combinations so that everyone gets what they want without having an opposite trade.
It’s Loopring’s mission to make trading cryptocurrencies secure, transparent, and more liquid by virtue of the above, and by allowing anyone to build on top of its decentralized exchange protocol. There is, however, a more profound implication. This combinatorial algorithm is a theoretical contender to replace the way humans (and machines) trade with each other. Specifically, it can obviate the need for formal currencies (and the prerequisite that we believe in the same currency), and leverage technology to trade directly from final good to final good.
Again, who cares?
Now, you may think, that’s intellectually stimulating (or maybe not), but who cares; our current system works fine, why would we ever switch from using currencies to facilitate trade? That is a fine criticism, but there are answers.
First, as mentioned, for our current system to work, everyone in a market must agree that the given ‘pricing’ currency, say, USD, has value. It doesn’t have intrinsic value (it’s just paper), but rather, value from a shared ‘story’. This story rests on our belief in the government, but much more importantly, on our belief that others will continue to believe this story and accept USD. What if I don’t believe in the USD because I know that no fiat currency has ever survived over a sufficiently long time horizon?
Or what if we’re not talking about USD, but about Zimbabwe Dollars, where 10 years ago inflation was rising by millions of percent a month? Meaning your banknotes lost their complete value in that time. If you had to trade in and out of Zimbabwe dollars to go from chickens to flowers, you may have lost your life savings in the process.
Why must someone believe in any intermediate thing to facilitate trade? That intermediate currency exposes people to risks they may not be comfortable with. They just want their damn chicken after all!
For these reasons, Loopring views everything as exchange rates, and not prices. There may come a time, especially with digital assets, when we don’t speak in price ($, BTC) per se, but in terms of pure end-to-end exchange instead.
This was the second post of a series on general financial market concepts. If you’d like a specific topic to be explored, please reach out or say so in the comments.