Are exchanges relevant if tokens are traded peer-to-peer?

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Are digital asset exchanges offering peer-to-peer trading?

The cryptocurrency markets have proved that peer-to-peer trading is technologically possible. This is not surprising. The original vision of blockchain technology was to replace trust in centralised intermediaries with trust in decentralised technology. The collapse of the centralised FTX exchange reinforced, rather than undermined, the validity of that claim. Which places centralised digital asset exchanges hosting the trading and settlement of tokenised securities in the paradoxical position of being centralised but also hosting peer-to-peer trading. To live with the paradox, centralised digital asset exchanges must pursue a hybrid strategy. To secure a regulatory licence, they must perform customer due diligence on all participants to ensure they are not in breach of Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening requirements. To generate activity, digital asset exchanges must also interact with other blockchain-based networks and with the systems operated by traditional financial institutions. While centralised digital asset exchanges can capture, settle and record transactions in native digital assets without intermediaries by using smart contract-based order books hosted on a public blockchain, not every user of a digital asset exchange can use such an infrastructure to trade, settle and safekeep assets on-chain. Regulated brokers and corporate treasurers, for example, prefer to operate largely off-chain at first, even if they eventually get comfortable with buying and selling tokenised assets with on-chain cash substitutes such as Stablecoins and tokenised money market funds. These constraints – the need for on-boarding compliance checks and to inter-operate with traditional systems – mean true peer-to-peer trading is possible only for participants that are wholly on-chain. But digital asset exchanges expect more and more business to migrate on-chain over time as the convenience and economy of peer-to-peer transactions - say, buying units in a tokenised money market fund via a smart contract using a Stablecoin - become obvious to bank and corporate treasurers. Certainly, it is too soon to say that peer-to-peer trading will not work. The task for digital asset exchanges is to identify the use-cases for peer-to-peer trading and persuade incumbents to make use of it by proving it can reduce costs through disintermediation, enhance existing products and services and improve the customer experience.

Would token markets benefit from netting through a central counterparty clearing house (CCP)?

The audience certainly thought netting through a CCP would be helpful. This is counterintuitive, given the theoretical preference of blockchain enthusiasts for gross, atomic, un-intermediated peer-to-peer settlement, in deliberate contradistinction to the credit and leverage-driven system of conventional, fiat currency-based money and securities markets. Yet at least one start-up is proceeding on the basis that the benefits of netting – reduced counterparty and settlement risk, greater capital efficiency, the netting and offsetting of collateral posted, and a reduced operational burden – are just as valuable in digital asset markets as they are in traditional financial markets such as equities, bonds, repos, swaps, foreign exchange and payments. Established CCPs are also alert to the potential threat, reasoning that, no matter how important their current role, the beneficiaries and victims of technological disruption are inherently unpredictable. The European CCP trade association engaged in detail in 2023 with another counterintuitive idea: decentralised clearing. (1) If and when disintermediation becomes unavoidable, CCPs will act to protect their franchises from disruption by blockchain-based markets. In doing so, they will be able to draw on longstanding relationships with powerful financial institutions that use their clearing services today.

Are digital asset exchanges incorporating netting into their business development plans?

For now, digital asset exchanges are proceeding without the benefit of netting through a CCP. However, they are aware that bi-lateral netting is sufficiently valuable to some brokers and banks to persuade them not to use an exchange at all. In this sense, peer-to-peer trading is happening already in traditional markets, and the opportunity for token markets is to bring that activity back on-exchange. Nor do digital asset exchanges expect existing financial market infrastructures such as CCPs to disappear as atomic settlement becomes widespread. Until the financial incentives to adopt tokenisation in general and atomic settlement in particular are truly compelling, the new and the old systems will coexist, and interoperate. Netting may survive even the eventual displacement of the traditional markets. This is unlikely to occur until wealth is fully transferred from the Boomer generation to their digitally native children and grandchildren. At that point, blockchain networks will incorporate “nodes” that clear and net transactions in tokenised assets. These nodes will be invisible to users but also valuable to them, just as other nodes run by artificial intelligence algorithms will deliver value by creating personalised portfolios for individual investors without them needing to make any decisions or take any actions at all.

Does peer-to-peer trading imply increased market volatility because it eliminates the role of market makers in smoothing market fluctuations?

There is a risk that, without the moderating influence of market-makers, buyers and sellers will drive digital asset prices up and down vertiginously by “swarming.” This is what happens in the cryptocurrency markets. In the conventional securities markets, by contrast, market-makers suppress volatility by providing liquidity consistently in a variety of market conditions by quoting bid and ask prices. The Automated Market Makers (AMMs) pioneered by the Decentralised Finance (DeFi) industry are intended to address this problem. Although experience so far suggests that AMMs have not solved the problem of price volatility – and that they suffer from other issues such as deliberate mispricing and market manipulation – their track record is encouraging. Even in the aftermath of the failure of FTX in November 2022, all contracts in the DeFi market were completed. In conventional securities markets, by contrast, market-makers tend to be unavailable when markets are truly turbulent. Like many if not most intermediaries in conventional securities markets, market-makers are rent-seekers in the good times that cannot be trusted to fulfil their duty in the bad times. On the narrow question of honouring contracts in a financial crisis, such as that of 2022, blockchain technology has proved more trustworthy than long-established and regulated intermediaries.

Is peer-to-peer trading suitable for some investors but not others?

Token issuance, trading, settlement and custody in their purest forms, being based on blockchain technology, reflect the mindset of a software engineer. The engineering axiom of “Keep It Simple, Stupid” (KISS) argues for systems that fulfil their intended purpose as economically as possible. Which leaves no room for intermediation, or a division of labour between brokers, exchanges, CCPs, central securities depositories (CSDs) and custodians. The engineering mindset sees no need for market-makers to manufacture liquidity in cases where the natural buyers and sellers of an asset are absent. Minds less focused on engineered efficiency are more likely to respect the checks and balances on risk in financial markets that have accumulated over time, such as clearing houses, market-makers and independent custodians. Similarly, adventurous cryptocurrency investors – known in the industry as “degens” - are more comfortable with self-custody wallets and metal back-ups to protect their seed phrases than institutional investors, let alone widows and orphans. A lesson of cryptocurrency investing, which applies to all forms of digital assets, is that there is no typical investor. There are self-custodying “degens” that engage in wild speculations on decentralised exchanges (DEXes) in assets that are off-limits to regulated asset managers and end-investors. There are technologists fascinated by the technical mechanics, keen to display their mastery of complex technologies and convinced they can make outsized profits by capitalising on it. There are retail investors in developing economies such as Argentina and Nigeria that invest abroad using Stablecoins and fractionalised security tokens to get round domestic capital controls, weak fiat currencies and relatively small amounts of savings – and they can be serviced without risking compliance breaches by reverse solicitation. There are retail investors in developed economies that are entirely passive, and which prefer to invest on centralised exchanges via full-service intermediaries that provide asset management, broking and custody services or via established and regulated asset management vehicles such as Exchange Traded Funds (ETFs). There are price-conscious retail investors in developed economies incentivised mainly by the lower transaction costs of tokenised investing. There are distributors such as private banks - and indeed digital asset exchanges - that can compliance-check and on-board retail investors on behalf of regulated asset managers. There are institutional investors in developed economies concerned primarily about remaining compliant and keeping their assets safely. However, such differences between investor types will matter little in a crisis, when investors of all kinds find they cannot realise the value of what they own by turning it into cash. Regulators are concerned about the impact of such a crisis on retail investors, whether they are invested via institutional intermediaries or not, since they tend to command the most political attention. A hidden danger for digital asset markets lies in the risk that self-custodying retail investors fail to protect their seed phrase or forget their password. Which is why security tokens – unlike cryptocurrencies, where the loss of the private key equates to total loss of the asset - are already protected by registrars which maintain the integrity of the issue and can cancel and reissue lost tokens. Experience suggests that intermediation by institutions is not an unnecessary cost for digital asset markets but a sine qua non of long-term success.

Will peer-to-peer payments accelerate the velocity of money?

In principle, peer-to-peer payments can increase the velocity of money, and so contribute to increased economic growth. There is some evidence that peer-to-peer payments funded from bank accounts such as PayPal, Apple Pay and Western Union and instant payments between bank accounts, even if not truly peer-to-peer or indeed even instant, are increasing the speed at which money circulates in an economy. Factoring was invented to enable companies to get paid earlier by selling their accounts receivable, and blockchain technology is being used to modernise the factoring market. The opportunity is to reduce the haircut taken by factoring companies by tokenising invoices and distributing them to alternative buyers through a digital asset exchange.

How difficult is it to move tokenised assets from a centralised or regulated digital assets platform or exchange to a self-custody wallet on another blockchain?

Cryptocurrency and digital asset exchanges often hold investor assets in a digital wallet on the exchange, which means the exchange itself holds the private key for that wallet address and so controls the assets. Assets are transferable to self-custodial wallets but the process can be awkward. A digital asset equivalent of Open Banking Application Programme Interfaces (APIs), by which investors would authorise third parties to access their data held on digital asset exchanges, would make the process simpler. Regulated banks and asset managers are certainly attracted by the opportunity to capture wealth held in digital wallets on exchanges. Building the necessary connectivity, including bridges and data standards, is largely a technical matter.  

Are the digital markets embarked on a long transition from centralised trading to peer-to-peer trading?

If digital asset exchanges enable established firms to trade existing asset classes in tokenised form at substantially lower cost – which means at least ten times lower - they will create an incentive to trade. At the same time, digital asset exchanges need to work with the systems and networks that incumbents have organised their business around, such as SWIFT. In other words, exchanges must be able to support non-tokenised, as well as tokenised, assets. Digital asset exchanges also need to price assets fairly. DeFi innovations such as Automated Market Makers (AMMs), which yield counter-intuitive results such as “impermanent loss” (a phenomenon in which the value of the tokens inside the AMM liquidity pool diverges from the value of the same tokens outside the pool), are not always helpful to valuations. Likewise, the data “oracles” that feed the smart contracts that execute trades on blockchains with the external information they need to act are dogged by out-of-date data feeds and allegations of manipulation. Digital asset markets may well remain fragmented because the underlying infrastructure is insufficiently respected and standardised to support efficient flows of capital between them. Some assets will trade and settle peer-to-peer on-chain and be self-custodied on-chain. Other assets will trade on-chain and net before settlement and custody off-chain. Some payments will be made peer-to-peer on-chain, disintermediating banks. It will take time – perhaps decades - before the digital asset markets scale and settle into the peer-to-peer model that blockchain technology has always promised – and perhaps not even then. After all, the differences in the ways in which different types of investors wish to interact with the financial markets are likely to persist, and digital asset exchanges will need to cater for those persistent differences.

(1)  he European Association of CCP Clearing Houses (EACH), Decentralized Clearing? An Assessment of the impact of DLTs on CCPs, EACH Forum paper, February 2023.