The dispiriting thing about the Securities and Exchange Commission’s 400-page proposal to re-engineer financial markets, and the response from outside the agency, is that lawyers and economists are arguing over questions that have easy technical solutions. If we wouldn’t trust these people to design the electrical power system or build a spaceship to Mars, why should we listen to them on market rules?
One basic issue the SEC is trying to address is how best to match buyers and sellers. The goal is not controversial: The person willing to pay the most should buy from the person willing to sell for the least amount, and these transactions should continue until every holder of the asset values it more highly than anyone who doesn’t hold it.
The trouble is that not every potential buyer and seller watches the market continuously, ready to make instant decisions. Therefore, intermediaries arise to provide liquidity. Economists study different market systems, and argue about which one is best, using different definitions of best. Regulators make rules to force the system to be better, cheaper or to favor certain groups. All of this leads to complex systems, prone to unintended consequences and unexpected crises, with lots of money syphoned by clever people and insiders.
Now consider crypto. To some, “crypto” means tokens with monetary value such as Bitcoin, and to others it means ledgers like blockchains. But I think of it more broadly as engineers applying rationality to problems non-technical people have squabbled over without resolution forever. Instead of arguing about what money is, make better money and put it in the public domain. Instead of regulating how records are kept, build a record-keeping system that meets everyone’s desires.
In crypto, designers started from scratch, not to entrench themselves in a legally protected oligopoly but to build exchange systems preferred by voluntary users. To date these have been used only for crypto assets, which has limited the attention they receive, especially when crypto assets are in decline. But the basic ideas are better, simpler and cheaper than traditional financial markets and should eventually supplant them.
Automated market makers let buyers and sellers trade asynchronously on their own schedules, so there’s no need to keep everyone in continuous contact for instant decisions. Liquidity has an explicit cost, rather than getting bundled implicitly in complex and immeasurable ways into prices. If you want to execute quickly or in large size, you get a worse price than if you are willing to be patient or are trading in small size. Each market participant can choose the amount of liquidity to buy with each transaction. The liquidity providers are paid explicitly in a simple way. There are no complicated rules with unintended consequences, lawsuits or political squabbling. And no expensive overhead with colocation arms races, speed bumps, circuit breakers, manipulation rules or regulatory analyses are needed.
Frequent batch auctions do match up buyers and sellers, but without pointless and destabilizing races to be first in line. All orders for a time interval — which might be a few seconds for high-volume stocks but up to a day or more for less liquid assets — are matched to a single clearing price. Intermediaries are still needed for those who want to trade more slowly than the batch interval, but the vast array of high-speed intermediary trading no longer exists. Only two order types, limit buy or limit sell, are needed, not the hundreds that exist today. Market making becomes a simple business relying on economics, not a high-pressure race based on outsmarting other algorithms.
Of course, these ideas are still being tested and refined. Perhaps the technical solution to financial markets is something different. But I’m confident it’s something mathematicians and computer scientists will design rather than something lawyers and economists come up with, and that it will be simple, transparent, cheap and fair.
Another major issue in market is protecting information. Legitimate traders want to protect information about their trades, while illegitimate market manipulators want to put out false information about their trades. Regulations are not suitable for protecting and filtering information — information always leaks despite the most rigorous procedures.
The technical solution here is zero-knowledge trading. With the magic of cryptography, it’s possible for an individual to encode a trade order before it leaves her computer, so that no one can tell who placed it or what the order is, yet an exchange can match it with a corresponding zero-knowledge order, without ever knowing what either order is (other than that one was an offsetting buy of something to the other order’s sell). The two orders can execute immediately and without credit risk via smart contract. There’s no spoofing, no manipulation because no one can see the false orders. There’s no front-running either.
Today there is vibrant, unfettered competition in crypto for the best exchange mechanism. Most important, ideas are tested with real traders instead of economists and regulators guessing about how they’ll work, and the tests are simple, without all the complexities of embedding them in existing financial markets. I don’t know if any of the ideas above will win out, but I predict whatever does win will make traditional financial markets look medieval in comparison. What the internet did for retail shopping, research, music, communication with friends and dozens of other things, it can do for stock trading — as long as economists and lawyers get out of the way of people who understand information processing.
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