The Modality of the Blockchain Stock Market
The train has left the station for financial operations moving onto blockchains as a layer for trusted settlement between parties. As of writing, billions of dollars worth of assets are providing liquidity on exchanges or are locked into peer-to-peer lending protocols in the fledgling space of decentralized finance. In a time when financial markets are starved for yield, protocols built on blockchains, predominantly Ethereum, provide tech-savvy investors the ability to capture interest rates that the traditional financial system could only imagine.
The beginning of decentralized finance is most often attributed to the launch of the Maker protocol in late 2017, which allowed, for the first time in history, someone to take out a loan without involving a centralized entity. Since these humble beginnings, the space has come a long way, but discussions about the “grail” of decentralized finance still mostly land on a stock exchange, which would fully usher in Ethereum’s reign as the settlement layer for the lifeblood of financial markets.
This idea has been discussed at length dozens if not hundreds of times. In fact, “tokenized” securities already exist, and companies are catching on to the advantages of this form of ownership. If a company were to have its entire ownership living on a blockchain like Ethereum, they get every piece of ownership verifiable and known, fractional ownership available from day one, automated compliance, real-time cap table updates, and tons of other unique advantages that blockchains bring to the table as the base layer of ownership for assets.
Automated Market Makers (AMMs)
If decentralized finance is growing at exponential rates and assets are moving onto blockchains, why then has a securities market not yet arisen to connect the two sides? Regulatory responsibilities aside (this is a subject that warrants an entire discussion [and article] on its own), we believe the current infrastructures of most decentralized exchanges (DEXs) are wholly inadequate for hosting a securities market that could directly compete with the NASDAQ or NYSE.
Presently, the dominant DEXs rely upon an automated market maker (AMM) model to source liquidity for their exchange. Billions of dollars of liquidity are locked into AMM contracts, allowing for a quick and relatively painless trading experience for the end-user, while allowing liquidity providers to put their assets to work and earn fees. The rise of AMMs is incredible to watch, simple mathematical algorithms are hard at work behind the scenes of every swap made on these exchanges, carrying the burden that once rested on order books hosting millions of bids and asks simultaneously.
A primary reason for the rise of AMMs and deviation from the norm of exchanges is rooted in something core to all blockchains: transaction fees.
Instituted as a mechanism to prevent spamming the core network, transaction fees are essential for maintaining the fidelity of the blockchain and forcing any bad actors to pay hefty prices for their attempts at manipulation. It also serves as an opportunity cost measure, forcing users to decide whether or not their interaction with the blockchain is worth the current fee. On the Ethereum blockchain, these costs are referred to as gas fees and are paid upon any transaction with the blockchain.
One can imagine that a hyper-liquid open order book exchange built on Ethereum would cause a rise in gas prices by having its order flow on-chain. AMMs come into the rescue, offering their services on an as-needed basis so the network is not burdened by carrying an order book that is updated to the second while still providing a liquid exchange for assets. AMMs also work well in hacking liquidity for smaller, newer markets, allowing for any willing liquidity provider to make a market to swap between two assets.
On-Chain Securities
The AMM model falls short of the requirements to build a securities exchange on-chain, ultimately because it is a temporary solution to a temporary problem.
Firstly, an AMM liquidity pool for company XYZ’s stock would require the pool to permanently hold a significant portion of outstanding stock. From both a practical and regulatory stance, this does not hold up. A company does not want to “stake” a large portion of their stock just to go towards facilitating secondary market liquidity. Shareholders are given rights like voting power, dividends, the right to inspect and examine company documents, and even the right to sue for wrongful acts. Shareholder governance is becoming increasingly important, and a pool of shares in escrow with the sole purpose of sourcing liquidity is a wasted portion of the cap table.
It’s also important to remember that in volatile markets, liquidity providers on AMMs can be subject to impermanent loss on their staked assets. If you want to read more about impermanent loss check out this article, but in essence liquidity providers are worse off when the prices of the assets they stake diverge from each other than they would be if they were simply holding the two assets, ultimately meaning liquidity providers are exposed to unnecessary levels of risk.
Security holders are subject to a KYC (Know Your Customer) check in the United States, and for good reason, companies should know who owns their shares and ensure that their shares are not being used for criminal activity. Quite simply, an AMM pool would be hard-pressed to pass these requirements, mapping every single sale to a single liquidity provider.
Lastly, inflated network fees are in the crosshairs of some of the best developer talent in the entire Ethereum community. Between EIP-1559 revamping the process of gas auctions, and layer 2 making progress with projects building on zkrollups and optimistic rollups, great amounts of both human and capital resources are working hard to reduce gas fees and increase throughput on Ethereum. As of writing, layer 2 solutions that would allow for a high-throughput and low gas cost open order book are available.
Open Order Books and the Future
By connecting users on an open order book built on Ethereum, Rubicon can fulfill the dream of a fully decentralized peer-to-peer exchange for any on-chain assets. Our team is building an open order book exchange for current on-chain assets so that when the stock market is ready to move on-chain, our venue is ready to host the exchange of securities.
A new era of capital markets will be born once the first company goes public on-chain. What the internet did to stock records that were kept on paper ledgers, the distributed ledger of the blockchain will do to stocks traded on the internet. The consensus was quickly reached that the internet was the ideal medium of exchange for trading, and not long after the entire securities industry had to move online. In the same manner, we know that we are currently at the tipping point of the financial system moving on-chain. With verifiable smart contracts, we can create an equity market that has full fidelity end to end, with no intermediaries between buyers and sellers trading their assets.
If you want to learn more about Rubicon and what we are building, check out our website where you can read our whitepaper and learn more about our thoughts on the future of finance. If you want to connect with us, follow us on Twitter or join our Discord server. To take a look at our protocol and follow our development, check out our Github. And if (somehow) you have none of these things, you can email us at contact@rubicon.finance.
