In their most basic form, marketplaces are simply places — physical or virtual — where parties can transact in items or services. Bazaars and auction houses, retail stores and stock exchanges, even job fairs and speed-dating events are all examples of marketplaces. What they all share is that they involve at least one seller, e.g., a provider of desired items or services, and one buyer, e.g., someone seeking said items or services, and an agreed-upon mechanism for an exchange of value between parties.
Of course, marketplaces in the real world usually have costs associated with trading, time lag in execution of trades or adjustment of prices and exploitable inefficiencies. We can’t always assume that sellers and buyers act in fully independent and rational fashion because countless variables skew and complicate the action of marketplaces.
We believe that truly removing friction and distortion from marketplaces requires rethinking them in order to enable greater stakeholding among participants and reduce value extraction by the few. These are core benefits of blockchain technology, and fundamental principles of community economics.
One example of a legal market abuse in equity trading is latency arbitrage, which is where a trader exploits a time disparity in trading in order to make money — often by gaining faster execution time or more real-time information access. This arbitrage isn’t based on making smart decisions (in fact, it’s often automated, run by computer algorithms utilizing what’s known as high frequency trading (HFT), jumping in and out of stock positions millions of times a second) — it’s based on watching what others do and using technological advantage to do it faster.
Another way to legally exploit discontinuity in information is to purchase proprietary data feeds, gaining access to more information than the competition, faster. Because exchanges control how this data is released, they have the ability to charge huge premiums to those who are willing to pay for the advantage that better data provides.
Finally, there’s also the practice by which some no-fee brokers make much of their income: Payment for order flow. This is money paid to a broker by a market maker to route their orders through them, instead of a rival market maker. It amounts to pennies for every hundred shares routed — but those pennies add up: these brokers make hundreds of millions each quarter from order-flow payment.
These factors make centralized exchanges vulnerable to abuse. Fragmentation and lack of transparency can lead to significant arbitrage opportunities, or even outright fraud, in exchanges like the OTC Pink Sheets, where there are few mechanisms to guarantee symmetrical information or protect against bad behavior.
Modern financial markets bear basic structural weaknesses that a handful of centralized, large-scale players are able to take advantage of, imposing real costs on the majority of market participants for the benefit of a few. The solution to this vulnerability would seem to be disintermediating the centralized players in our complex financial system.
That’s where the technologies that are moving to the center of the next iteration of the web come into play, most prominently among them blockchain. By providing a means to decentralize and disintermediate marketplaces, blockchain offers a way to create new exchanges that level the playing field among stakeholders and mitigate many of the abuses inherent in “traditional” exchanges. At the same time, decentralized exchanges are not without their own vulnerabilities — some of which mirror those of traditional exchanges, and some that are new and unique to blockchain-based systems.
Want to learn more about how the blockchain can reduce marketplace friction? Read our in-depth article here.