Re-Thinking The Exchange Model
The blockchain and related cryptocurrencies are poised to be the ultimate financial disruptors. However, many fail to see cryptocurrencies real advantage when it comes to investment vehicles and financial technology.
Currently, most of the cryptocurrency investing platforms just mimic established trading systems. However, there is real opportunity to re-invent how financial trading is accomplished. Right now, most trading is based on ancient market technologies that have been modernized with computer based record keeping.
Sure, two parties can exchange cryptocurrency. However, there is no decentralized means to place an order for cryptocurrency or other crypto asset. Everything has to go through an exchange or an independent person.
Once traditional banking takes over trading of cryptocurrency, it will not matter that the currency is decentralized. The Chicago Board Options Exchange (Cboe) is already offering Bitcoin Futures and NASDAQ announced plans to build a cryptocurrency exchange.
FOREX represents a decentralized collection of fiat currencies issued by multiple Central Banks. However, the control of prices are largely set by market speculators. Such as in 1992, when George Soros became famous for breaking the Bank of England by shorting the British Pound and pocketing $1 billion in the process.
The problem is, it is very difficult to imagine entirely new paradigms. That was what occurred when Bitcoin was created. So why stop there? Why not re-think the exchange model entirely? What if there was a decentralized means of fair trading blockchain based assets with near perfect liquidity?
One example is replacing the exchange model with something similar to Google AdWords. While not decentralized, AdWords represents an automated auction system that only works when needed. For example, an ad for an unpopular keyword at a high bid will get displayed when relevant until the buyer’s limits are reached. In contrast, the more popular keywords will go to an automated auction with a combination of factors determining what ad is displayed.
In a decentralized exchange, buyers and sellers subscribe to a network. To buy an asset, one places an order by selecting the asset they want to purchase and entering an amount in one of the available currencies along with quantity. Including an expiration for the order. Meaning if it is not filled in n time then it is cancelled unfilled.
If there is a bid matching the ask, the trade is made and all transfer occurs without human intervention. When no match is available, the ask is presented to the network, giving participants the option to sell at the requested criteria. This occurs via an API endpoint for either automated responses or a manual response from a third-party interface.
Selling an asset requires one to place a bid on the network. For example, ETH/BTC for 0.08 BTC with quantity of 2 and expiration of 7 minutes. Once published, the bid is matched with the next ask that satisfies these requirements from the queue. If a match is not available, the bid is presented to the network, giving participants the option to buy at the requested criteria until expired.
Each order, bid or ask, is represented across the applicable networks as a smart contract. To ensure a fair market, each trade must have a minimum execution time and a limit to how many trades can occur by a single participant each hour.
While not foolproof, these stipulations allow two separate markets to exist on a single decentralized exchange. One for institutional investors to trade large quantity blocks and one for individuals to trade smaller quantities at a time. All from the same network.
The only remaining issue is liquidity. Traditional exchanges have market makers who buy and sell assets at specific published prices. They do so to make money from the bid-ask spread. However, they also manipulate prices and cause volatility due to their activity.
Once the pool of active participants reaches a critical level, there is little need for a market maker to produce liquidity. The only exception being to buy or sell unpopular assets.
Classifieds like Craigslist do not have a central buyer or seller of goods. If a buyer lists an unpopular or unwanted item, it will not sell. The more popular an item listed is, the more liquid it becomes. In contrast, eBay acts as a market make for antique dealers and pawn shops. This is due to the millions of market participants who make obscure items more liquid than at any other time in history.
A good starting point to re-think traditional markets is eBay and the many websites like them. Consider if online marketplaces allowed participants to buy or sell stock like baseball cards. How would pricing differ? Would the market be more or less liquid?
Auction sites create a market based on near perfect supply and demand. If a certain item’s demand is higher than its supply, prices go up. If the opposite occurs, the price drops. However, there is still interference based upon the off market activity of professional sellers. Consider a popular christmas toy. Sellers often purchase large amounts of such items to artificially increase the shortage, causing the price to inflate past what is natural market behavior.
The proposed decentralized exchange cannot eliminate such behavior. However, it does nothing to exacerbate such risk. This is the same risk any market has — an artificial alteration of the price. If anything, it reduces the risk due to being a global network.
Since the exchange is decentralized, there is no individual entity to profit from spreads or exchange fees. In theory ensuring a fair market for all. A side effect of this is near anonymity for exchange transactions due to no central collection of personal information. So even those persons in highly restrictive countries could move their wealth into something globally portable.
The entire decentralized exchange is a worldwide fair market. Anyone from any country could buy and sell crypto assets without market manipulation or large barriers to entry. Is this a solution for third-world economies to prosper? Maybe. The important question is could such a re-think of investing give individuals greater control over their finances.