Peer to Peer exchange of value
The issuance and secondary trading of the programmable instruments can be done through a number of methods in a decentralized way. We explore the various approaches and look at a more general exchange of value in a peer-to-peer (P2P) setting.
The traditional capital markets world has a multiple layer approach with a series of intermediaries and all of them play a role in securing the infrastructure.
An exchange restricts the market participants to licensed institutions who need large capital reserves so, in case of failure the market as a whole is protected, they also need to demonstrate they comply with rules to ensure orderly markets. The Central Counterparty (CCP) was introduced to ensure that the transactions made would be guaranteed and mitigated the risk of a counterparty unable to fulfill their transactions. This became apparent in the liquidity squeeze of 2008/9. The clearing of the transactions also required the participants to move their inventory to a Central Securities Depository (CSD), this mitigated the risk of failure to settle due to missing inventory.
When we look at this with a “decentralized first” mindset and question the purpose of these mechanisms we can start to understand what the alternatives are and whether the safeguards are in place. The prime concerns are a fair and orderly market, and robust mechanisms to mitigate the risks of counterparty risk within the infrastructure. The decentralized alternatives all address the counterparty risk issue, the issue of the fair and orderly markets is addressed with varying degrees in the decentralized alternatives.
There are many flavors of Decentralised exchanges (DEX) which are broadly order book mechanisms, where the depth of buy and sell orders are shown. The orders match and are instantly settled.
There have been issues with some DEX due to the lack of liquidity and some reported front-running with strategies such as paying higher fees to get priority over other orders.
Automated Market Making
Automated Market Making (AMM) comes in many variations, at the simplest they work by creating liquidity pools and the price is set according to supply and demand with a simplistic formula that has a constant around which the price is set. There are more complex versions that use oracles to source prices from other markets and use that to adjust the market price rather than relying on pure supply and demand.
AMMs meet the criteria for ensuring there is no counterparty risk and as a mechanism, they offer fair and transparent markets.
The beauty of Period Auctions is that the mechanism is well tested, the traditional markets use these for primary issuance to establish the market price. They resolve the issues of front-running as they are batched executions and they offer a fair market as the auctions match the buyers and sellers who are active in the auction. The period auctions can be run every second, thus creating a continuous market.
The mechanisms around ensuring that the bidders and sellers have the right inventory needs robustly designing to ensure that counterparty risk is mitigated. The test for fair and transparent markets is passed as the frequency of the auctions establishes continuous means for price discovery and the auction matches the supply and demand of a given instrument.
Exchange of Value
The multiple-dimension programmable instruments have a value which factors in a financial element and the ESG or Stakeholder credits. The exchange of this value will follow the mechanics of supply and demand, and the current infrastructure will be able to accommodate these instruments in the conventional way.
There are some questions around multiple-dimensional programmable instruments and the accrual of the credits. Are the credits fungible or non-fungible? Is there a demand for the credits to be traded separately or is the integral value in combining the financial and the credits as an overall representation of value? If the credits are non-fungible and there is a demand for them a synthetic credit could be issued.
Having one side of value in the multiple-dimensional programmable instruments we need to consider the other side of the exchange, which can be envisaged as a stable coin or e-money. This is not necessarily a precondition and there can be other instruments of value that can be exchanged.
What is clear is that we can consider the exchange of pure financial instruments a limited proposition compared to the exchange of value with multiple-dimensional programmable instruments.