The Decentralized Exchange

The crypto world sometimes takes things to extremes and pushes the envelope. I think this is okay. After all, when you take a serious study of economics you always look at extreme cases and what happens at the margin. How much does it cost to make one more? How much revenue can I generate by selling one more?

I am appreciative of the framing and view that people advocating for decentralized exchanges are taking. There is a lot of power concentrated inside an exchange. It’s more than just the data. On the SEC side, there is listing requirements. There are transparency requirements. There are plenty of other rules and regulations that turn over power to centralized exchanges. On the CFTC side, it’s about clearing. Because exchanges own their own clearinghouses, they have an incentive to innovate and respond to customers. But, at the same time they have a lot of pricing power over all kinds of things because they own their own clearing.

It’s a tradeoff and economics is about tradeoffs.

There are tradeoffs we make when we trade on an exchange.  Some of it is security.  Some of it is a more competitive marketplace.

My friend Professor Craig Pirrong wrote a piece about decentralized exchanges. Craig is an expert on exchanges. He is always a good read but I thought this particular piece was pretty good in explaining why exchanges work.

Centralization reduces the cost of finding a counterparty. It enhances competition, which tends to reduce bargaining costs. It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs. Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs. This is clearly what is happening in crypto world. Indeed, the main puzzle at present is why there are so many exchanges. The centripetal forces of liquidity will likely result in a huge consolidation in this space.

I saw this piece that said decentralized exchanges are having trouble and so far have not been successful.  The jury is still out on whether they can disrupt traditional ways of market-making and trading.  I am willing to be patient and watch.  But, there are big economic benefits to centralization.

Another product that seems interesting intellectually but probably won’t work is stable coins.  If you want to hedge risk in an asset, all you need is a futures market and an options market.  They work, provided a lot of liquidity and add to the depth of the cash market.

When we demutualized the CME, we had some very deep and long discussions about disintermediation.  This would mean that the exchange would go direct to customers and get rid of layers of distribution.  It would allow CME to capture first, second and third degree price discrimination in the marketplace.  We concluded that for this time, and this exchange it was not a feasible idea.

But, today’s crypto exchanges have disintermediated some layers of distribution.  That’s enabled them to grab more of the surplus that is derived from transactions.