Building the next generation of trading infrastructure
This past year, the SheeldMarket team has worked hard to build privacy-preserving financial infrastructure with the goal to give back to users control over their trading data and ultimately earn their trust. This article is a way for us to share our experience and start a conversation where we explore different themes around modern capital markets, from basic economics to high-frequency trading, as well as cryptocurrencies.
Of open marketplaces (and their consequences)
A marketplace is a meeting place for people with slightly differing views on what the price of an asset, good or service, should be. Because participants do not agree on any specific price they usually buy or sell the same product at different prices. Once there are enough market participants prices converge to a consensus called the fair value.
This process is called Price Discovery and applies to all markets, including the stock market.
Once a market has reached critical mass allowing fair price discovery, another behavior emerges. If a participant is actively trading large sized orders, their intention becomes obvious to the market and other participants react by making the large player pay more to achieve their large target position. This phenomenon is known as Market Impact which combines Information Leakage and its corollary Price Slippage.
In order to mitigate impact, the industry is using more and more sophisticated execution algorithms whose role is essentially to obfuscate its real intention. However modern tools like machine learning techniques and trading bots are able to detect such patterns and profit from them. These predatory participants are usually referred to as High Frequency Traders. To address this new type of Information Leakage, the financial industry has come up with black hole like trading systems where information enters but never exits.
These systems are called Dark Pools. A Dark Pool is like any other stock exchange but does not publish order book information. Market participants are trading in the dark, therefore Information Leakage is no longer possible.
This theory works under two conditions. First (1) a critical mass of market participants must be achieved. Second (2) all market participants operate on a level playing field. The latter condition implies (2a) equal treatment for all buy and sell orders and (2b) equal access to information. In the case of Dark Pools, this translates into (2c) no information for any parties.
Transparency is a double-edged sword
In practice, experience has shown this world does not exist. Because most dark pools are operated by large entities such as investment banks and large trading firms, there are inevitable conflicts of interest even with the strictest level of Chinese walling.
For example, one dark venue¹ allowed its customers to choose which category of counterparts to be matched with, based on aggressiveness levels, while actually matching them with high-frequency traders (2a). Another entity¹ offered select participants access to orders with sub-penny increments, allowing them to jump to the top of the order book without bringing significant price improvement. No-one could know because the venue is dark, by definition (2b). A third example is a venue¹ that fed the supposedly private order book data to an affiliated prop trading team, meaning they were basically trading on a lit venue (2c).
This happens because a 100% secured process involving human interaction does not exist. The ideal dark pool should be able to guarantee a level playing field and enforce confidentiality while operating in complete transparency. In addition, built-in mechanisms should reward good citizens and penalize toxic predatory behavior. And of course, doing all of this automatically in an efficient, audited and regulated manner.
Squaring that circle…
At SheeldMarket we believe such a marketplace can be implemented. In fact, we have built a first version of this Trusted Matching Environment (TME). This system routes and matches orders through a hardware-level security perimeter: physically isolated processing power and memory that prevent any external entity, including the operators, from accessing the data that’s in it. Every step of the process generates a Zero-Knowledge proof to provide process transparency to the participants, regulators and auditors.
This system makes sense for three reasons. Firstly, hardware isolation allows for low-latency computation. Existing financial technology providers targeting the same problem use privacy-preserving frameworks like sMPC which are mathematically secure but too slow to handle continuous matching, which represents the bulk of dark pool trading volume today. Current sMPC technologies have 1ms latency². Meanwhile our product has a 1μs latency on retail hardware, which is 1000 times faster.
Secondly, this system doesn’t change the current dark pool workflow. Everything stays the same: protocols, connectivity and order types.
Finally, the Zero-Knowledge proofs allow users to find a trade-off between predatory behavior protection and maximal liquidity. We offer rebates and enforce penalties depending on trading behavior, while making the entire process transparent. Our participants are free to choose how exposed they want to be, and they can do it in full confidence.
Cryptocurrencies: Only the first step
Having a TME meeting our goals is only the beginning of our journey. Our next steps are to be fully regulated by the AMF (France’s SEC) and launch our cryptocurrency marketplace with early access participants during Q1 2020. We chose to start with cryptocurrency for three reasons.
The first is a lower barrier to entry. There are only few competitors, none having captured the current trading market, making it easier for us to create a strong brand and top position. Additionally, the French government recently approved a robust regulatory framework for digital asset businesses³ therefore creating a legally stable space to operate.
The second reason is that this market is still evolving, there are many players that are yet to enter the space and we want to be their point of entry.
And finally, it is currently difficult to execute large cryptocurrency trades. Liquidity and demand are fragmented on multiple platforms, and traders are only comfortable sending large orders to principal OTC services where they know they’ll get instant pricing with minimal information leakage. Few feel comfortable placing large orders in public, centralized exchanges where they can rip the order book in milliseconds and take the risk of being moved behind in the queue by the exchange operators themselves who see a risk-free arbitrage opportunity.
The case for an “AWS” of financial infrastructure
On the long term, our vision goes beyond cryptocurrency and beyond Dark Pools. Most financial businesses have to run complex infrastructure for execution, pricing and research. The infrastructure itself does not differentiate them, rather the expertise they apply over it, yet they still spend enormous fixed costs to maintain it as a necessary means to run their core business. Small firms cannot even afford proper infrastructure. We believe there is a market for the “AWS” of trading infrastructure, allowing any financial service firm to focus on their core business and innovations⁴ ⁵, while relying on us for on-demand, privacy-preserving trading infrastructure.
Such a platform can bring them many benefits. Predictable, lower costs of ownership and operations is one obvious gain. Another one is better performance out of the box as our team of experts keeps the systems updated to the best and latest standards. Easier and more affordable compliance is also made possible, as our users wouldn’t have to maintain Chinese walls between their market and service provider activities⁶. And many more.
Using our technology buy-side firms of all sizes can easily internalize their trades. They can research, backtest and validate their trading strategies and execute them at the highest level of performance without needing a dedicated IT department. Broker-dealers, mid-cap or otherwise, can spin up on-demand pools of liquidity, for example in the Private Equity space. Market makers and investment banks can benefit from running Systematic Internalizers and Dark Pools without being burdened by conflicts of interest and compliance⁶.
We believe our Trusted Matching Environment and its technological innovations have the power to improve the cryptocurrency world and beyond that the financial sector at large. We think the financial market will embrace cloud computing given the right tools, and SheeldMarket can be the ones to make that vision a reality.
¹ Dark Side of the Pool — Healthy Markets Org
² Halevi, Tzipora, et al. “Initial Public Offering (IPO) on Permissioned Blockchain Using Secure Multiparty Computation.” 2019 IEEE International Conference on Blockchain (Blockchain). IEEE, 2019.
³ Loi PACTE — Authorité des Marchés Financiers (AMF)
⁴ https://www.fisglobal.com/insights/what-we-think/2019/april/why-banks-should-outsource-it
⁶ Reg ATS-N (701) — SEC
SheeldMarket designs, builds and operates privacy-preserving trading infrastructure, protecting market participants from conflicts of interests, and allowing firms to outsource their infrastructure while keeping control of their data. Our first product is a cryptocurrency Dark Pool.
