This is a primer on marketplace design, market microstructures, and market-making from our combined 30+ years of experience in electronic trading at Tower, Citadel, Goldman Sachs and SGX. Whether you are a trader, a project launching a token, or an academic, we hope you find this four part series useful.
Part I: Marketplace Design: General theories and background information
Part II: Crypto Marketplaces: A discussion of some of the unique features of crypto marketplaces and how they are distinctive from traditional financial exchanges
Part III: Market-Making on Crypto Marketplaces: What does market-making actually mean, and how does it work?
Part IV: How to Work with a Market-Maker: Choosing and working with the right partner
“The world is a marketplace, Mr. Beale, and it has been since man crawled out of the slime”
-Arthur Jensen from the cult 1976 movie “Network”
It wouldn’t be an overstatement to posit that human civilisation began when humans walked out of their caves and began to exchange the fruits of their labor with others. The formation of cities, particularly near waterways, had one singular practical purpose: to facilitate exchange. Centuries later, market places may look very different from the ancient ports of Basra and Caesarea, but their function remains intact. And in a world spun by capital, it is financial exchanges that set the skylines of our cities today.
The fundamental principles underpinning financial exchanges are their function, organization, mechanism, and the value added to our lives.
To define an exchange, we start with a marketplace. Broadly speaking, a marketplace is a venue (physical, virtual, or electronic) that brings together parties to a transaction. A wet market is a marketplace bringing together mongers and grocery shoppers, but so are e-commerce platforms like Amazon or Alibaba bringing sellers and shoppers; Google search, bringing together content providers and seekers; and Uber and Grab, bringing together drivers and passengers. Playstation, Linkedin, Spotify, and Tinder are likewise marketplaces in their own industries, connecting respectively developers with gamers, employers with employees, musicians with music aficionados, and people looking for love.
At the root of the successful functioning of a marketplace is the network effect, i.e. the propensity of seekers to gravitate towards where there are providers, and providers to gravitate towards where there are seekers. When they all come together, the best offerings meet the best prices, maximising the value for all and exerting gravitational pull for new participants. Thus large and incumbent marketplaces grow increasingly larger and more dominant. A classic example is the case of Apple’s immense pricing power within the Appstore — where app developers sell services to the wealthiest of smartphone users and have no choice but to pay a 30% cut to Apple on their sales.
The largest financial exchanges today trace their roots centuries ago, like the NYSE dating as far back as 1817. Electronification started in the early 1980s but didn’t take up in earnest till the early 2000 with the arrival of high frequency traders (HFT).
The typical development of an exchange follows either a J-stick growth path or a quick demise, but never anything in between. While product design, starting capital, and political backing are certainly portentous factors in the successful attainment of critical mass, the greatest factor by far remains chance.
While their core function remains the same, exchanges vary greatly in terms of their charter, governance, services (most commonly listing, trading, clearing, and regulation), rules, products, participants, and sets of protections. We give an overview here of the major dimensions in which exchanges differ.
The foremost function of an exchange is trading, which refers to acting as a venue for buyers and sellers to come together together and negotiate a transaction. Furthermore, exchanges impose strict processes on that negotiation as well as exact guarantees that it is in good faith.
The next function an exchange commonly serves is clearing. Once a buyer and seller are matched, the buyer owes the payment and the seller owes the delivery. The exchange “cuts the trade in two” and interjects itself between the two parties. From that moment on, both parties face the exchange, as in the buyer owes the payment to the exchange, and the seller owes the delivery to the exchange. The exchange thus becomes a counter party to both sides, in effect acting as what is known as central counter party (CCP). Thereafter, the exchange becomes responsible for settling the trade. Settlement largely looks like this:
It is of note that an exchange could choose to only engage in either clearing or trading and outsource the other, as they are not necessarily coupled.
Other popular functions of exchanges are custody of assets (e.g. shares certificates), data dissemination (inclusive of market data and indexes), listings, and regulatory.
From the rowdy trading floors portrayed in classics like 1983’s “Trading Places” and 1987’s “Money Never Sleeps”, to the quietly humming server rooms effecting light-speed dark pools, exchanges offer various mechanisms via which buyers and sellers meet and come to an agreement.
We often differentiate between:
Furthermore, the matching could be anonymous (participants don’t know each other’s identity) or not.
Different matching mechanisms lend themselves to different products. For example, products marked by uniqueness — like art, real estate, fixed income — naturally benefit from pooling liquidity into a single auction/open house, while homogeneous fungible products — like stocks and equity options — historically tend to develop continuous markets. Furthermore, being listed in a single geography, stocks generally trade during office hours, often over multiple short trading sessions, whereby the intermissions like lunch breaks are commanded not so much by the physiological needs of institutional traders but rather by the desire to concentrate liquidity over a shorter period of time to improve price formation.
Trading in markets dominated by institutional players — like the bond and the FX spot markets — tend to see large one-off OTC trades negotiated off-exchange and only subsequently booked on-exchange; in contrast, markets with significant retail participation tend to attract HFT market makers and see a distribution of trade sizes skewed towards numerous small trades matched on-screen, as retail traders generally trade in small clips.
Among the primary responsibility of an exchange, particularly with respect to derivatives, is the design and approval of the tradables. Designs vary greatly on account of the numerous asset classes transacted on exchanges, but even within an asset class, there are a myriad ways to set the contract specifications. Taking the example of single stock futures, a type of delta-1 derivative on a stock, the contract specs must spell out:
In other cases, for example an index option contract, the contract specs must make explicit:
In many ways, the most important yet most underappreciated differentiation of an exchange are the layers of protections it awards to its participant. A traditional exchange would normally employ a a waterfall of safety mechanisms to ensure all transactions go through. To list a few (which my differ in presence and in naming across exchanges):
The exchange rules comprise the do’s and don’t’s, the laws and bylaws, the general rules of engagement and modus operandi for all parties involved: traders, brokers, dealers, regulators, and retail. Those rules are communicated by the exchange via directives, regulatory notices, practice notes, and circulars, with the exchange acting in its various capacities of a market operator, regulator, self-regulatory entity, and custodian.
The rules for different exchanges can vary widely, and in turn these rules will incentivise drastically different behaviour from various classes of traders, be they retail, family offices, proprietary trading companies, hedge funds, institutions, municipal or sovereign.
Rules exist and are enforced as a means for ensuring fair and transparent operation of the market — a broad stroke definition that grants exchanges broad purview to intervene to protect the interests of certain vulnerable groups (like retail) as well as the market operation as a whole. Exchanges thus exercise broad discretionary powers to, among others:
Having examined exchanges from various angles — their history, purpose, and organization — we have set a foundation for both how to design exchanges and how to interact with them. In the next parts, we will consider the different layered types of interactions on exchanges and how to design and incentivise behaviors.
Up next…Part II: Crypto Marketplaces
This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of AlphaLab Capital Group or its affiliates and does not necessarily reflect the opinions of AlphaLab Capital Group, its affiliates or individuals associated with AlphaLab Capital Group. The opinions reflected herein are subject to change without being updated.
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of AlphaLab Capital or its affiliates and does not necessarily reflect the opinions of AlphaLab Capital, its affiliates or individuals associated with AlphaLab Capital. The opinions reflected herein are subject to change without being updated.