Bankless 74 - The History of Electronic Markets - Tarun Chitra

Primer: Markets are places where transactions between parties occur. The advent of the internet ushered in the era of the electronic markets. In this Bankless episode, Tarun Chitra takes listeners through the 3 eras of the electronic markets and delineates the features of each.

A Brief Walk Down History

  • Tarun's Mental Model: Three Eras of Electronic Markets

  • Earliest form of a market: A bazaar in the center of the city, with a bunch of people having stalls

  • New technology tends to be first used in a financial setting

"Every new form of technology that has been invented, inevitably finds its first usage ad adoption in financial markets." - Tarun Chitra

  • Telegraph, when it was first invented, was used as a Business-to-Business (B2B) device

  • Invention of the telephone opened up new markets (e.g. telemarketing)

  • These markets were peer-to-peer (in a bad way). People had to manually find a buyer or a seller

  • Creation of the internet in the 1970s and people in finance (in the early 80s) realized it was a good way to price assets

  • However, there were still limitations. People have to schedule an appointment with their broker to buy shares in the mutual fund

"That's the vestige of that time where like, in order to buy stocks you'd like go to a physical venue, you'd pay someone like 5% to execute the trade, if you're lucky, and then it would go through a series of middlemen, and then they'd go to banks and banks were the only ones who kind of dealt with the stock exchange for you." - Tarun Chitra

What Are Electronic Markets?

Definition And Scope

  • Refers to the idea of replacing middlemen with compute power and communication via the internet

  • In the 80s, people realized that the removal of intermediaries in banking could improve efficiency

  • This started a trend and, today, people can trade stocks using apps like Robin Hood without the need for intermediaries

Common Themes In Each Era

  • There's always a boom and bust cycle

  • In every era, there is a new technology or regulation that is introduced that shifts the market microstructure and how people interact with the system

  • Each era makes the market more competitive, lowering prices for people

Electronic Market Era 1.0

Characteristics

  • Happened in the 1970s

  • People were physically present at the stock exchange raising hands/doing hand signals to purchase/sell shares

  • Communication of their orders is known as Open Outcry

Consolidation In The Market

  • In the 1970s, every city in the US has their own stock exchange for buyers and sellers to meet physically

  • Consolidation happened in the industry (e.g. New York Stock Exchange bought the Philadelphia Stock Exchange)

  • People could now buy/sell stocks from other stock exchanges. Their local stock exchange would relay it to the New York Stock Exchange for a relay fee

  • Market was inefficient. Trades can take days to get executed

The Advent Of The Internet

  • When the internet came out in the late 60s/early 70s, people realized that they could communicate information about bids and offers between different stock exchanges without having to physically relay their orders

"This was the first aggregation effect due to the internet. It's literally aggregating liquidity across different stock exchanges." - Tarun Chitra

  • Analogous to relayers/order routers on the blockchain

Where Innovation Occurred

"But the idea is that it's the kind of esoteric assets that have weird computational needs, or weird sort of behavior are always sort of the earliest assets to get adopted by new electronic markets. And so, options kind of lead the 80s." - Tarun Chitra

  • Innovation happened at the more esoteric and new assets first: Options

  • Options: The right to buy or sell a stock in the future

  • Math for options are computationally intensive and there needs to be a lot of communication about their liquidity as to where the bids and asks are. The existing Open Outcry format does not suit options because of those 2 reasons

  • Each new era of the electronic market removes a layer of lawyers through automation

Options During Era 1.0

  • Options were mind-blowing inventions at that point in time

  • People began experimenting with riskier kinds of options

  • Crash in 1987 partially driven by options

  • Banking institutions called Thrifts offered higher interest rates (relative to normal savings accounts) and were not FDIC insured. Depositors deposited money to Thrifts which, in turn, lend them out to people buying 15-30 year mortgages

  • Inflation in the 1980s and the yield is worth less over time. To pay depositors, Thrifts started to take additional risk by trading options and it contributed to their collapse later on

New Entrants To Finance

  • During the first era, academics in maths and physics came into finance to do quant math modeling

  • By the 90s, people had a better understanding and computer scientists and technologists entered finance

Regulatory Actions

  • Regulators focused on Thrifts

  • Consolidation in the banking industry. Citibank went on a M&A spree

Electronic Market Era 2.0

Characteristics

  • People FOMO into tech IPOs (e.g. pets.com)

  • By then, electronic markets made it cheap enough for new entrants to reach retail users. They are like an early form of Fintech

Start Of The Era

  • People have their first computer and have access to the internet at home

  • In 1997, retail users FOMO into buying stocks as it was more accessible than before

"[On the Dotcom boom] People had a bit of exuberance just like we see in crypto time and maybe went a little crazy." - Tarun Chitra

  • The market eventually broke down. Failure in clearing and settlement. Brokers promised a certain amount of shares but they were not delivered

"And so there's kind of this theme that whenever there's a big blow up, oftentimes you find under the covers that there's this kind of assets that people don't realize hold risk, but actually, you're holding a ton of risk." - Tarun Chitra

Innovation In This Era

  • Lots of new financial products in this era (e.g. tradeable mortgage-backed securities of different forms, volatility futures, ETFs)

  • This is the era of Moore's law: compute power doubles every 18 months on average. Require fewer lawyers as algorithms are written to quote prices

  • Mobile phones were starting to take off

"So this was the era when people started really, for lack of a better phrase apeing into passive investments, and this completely changed the market structure of the financial markets." - Tarun Chitra

Regulatory Actions

  • In the middle of this era (2003 - 2006), the US government implemented the Regulation Neutral Market Service (RegNMS). Every market had to look at other exchanges and quote the best price for a given asset

  • For example, previously, NYSE could offer GM shares price at $30, and NASDAQ could offer it at $25. With RegNMS, both exchanges (NYSE and NASDAQ) had to offer GM shares at the same price

  • This caused a consolidation in the number of exchanges and created an oligopoly of market makers

  • Price has to be synchronized across all exchanges. Exchanges do not want to become traders; they just want to collect fees on volume. Exchanges invented market maker rebates where market makers come in to arbitrage and make sure that their price meets the RegNMS rules

The Emergence Of ETFs And Adverse Selection

  • Rise of ETFs and passive investing in this era

  • Adverse selection: Having to buy shares every day to maintain the ratio between the shares within the ETF

  • People will front-run the ETF in buying shares just before the ETF rebalances

"The advent of passive investing vehicles meant you didn't have to do all sorts of weird structuring because the passive investing vehicles made this arbitrage game a little bit like Uniswap." - Tarun Chitra

  • An ETF share is created by handing over the shares to an ETF underwriter and receiving an ETF share in return

  • Kind of like depositing tokens (e.g. 50% ETH, 50% USDC) into a liquidity pool and getting a LP token in return

  • If someone spots a price deviation, they could arbitrage between the ETF share and the underlying shares

  • Arbitrage game becomes profitable by buying orderflow from ETF underwriters and executing it and ensuring that the price stays synchronized

Impact Of Electronic Markets

  • Electronic markets enable small firms to quote much faster than banks

  • Consequently, banks no longer market make in a passive investing world. Instead, they sell their order flow

  • This leads to further consolidation in the industry

Exchanges In Era 2.0

  • Smaller exchanges sold out to the larger exchanges

Order Prioritization and "MEV (Miner Extractable Value)" in Era 2.0

  • Closest analogy to MEV in TradFi is High Frequency Trading (HFT)

  • Exchanges sell co-location to HFT firms for faster trade execution speed

  • Co-location: renting a server in the same data center as the exchange to get an edge in transaction speed over others

  • Huge arms race over better hardware

  • The sector consolidated and profits flatlined

  • HFT happened at the end of Era 2.0 as people wanted faster execution to lower the information difference between market participants

Comparison between Era 1.0 and Era 2.0

Electronic Market Era 3.0

Characteristics

  • Started at the peak of HFT and the entrance of Crypto and retail apps like Robinhood

  • Era 3.0 is marked by increased access to the market

Theme Of The Era

"I think the theme of phase three is internet culture and memes, will beat suits, in some sense." - Tarun Chitra

Underlying Technology

  • Crypto is the new technology that replaces intermediaries

  • The mobile phone. People got comfortable with finance applications on their mobile phones

Insights On Era 3.0

  • Previous eras are in the existing financial system. Era 3.0 is newly created from the bottom-up

  • It has an exploratory playful nature, reminiscent of the early 80s

  • Risk is increasing over time as people are experimenting and using assets in unintended ways

  • Institutions have better risk management than retail users

Will Experimentation Lead To A Crash?

  • We have experienced a few crashes and will experience some more in the future

  • Crashes happen faster in crypto

  • Eventually will have tools that could be used to assess risk

"And in DeFi land, it's even wilder, because the risks are sort of when you have a composable network of apps. You know, figuring exactly how to hedge under any possible user behavior is quite different than just hedging the exposure to the stock price." - Tarun Chitra

Removal Of Lawyers In Era 3.0

  • Views Uniswap liquidity shares and their generalizations as ETFs. No longer need investment banks/lawyers to be the underwriters; the smart contract is the underwriter from the perspective of the liquidity provider

"Instead of needing lawyers, the EVM is the lawyer, right? The EVM is the law. And so not only have we broken away from lawyers, but we've also broken away from regulations, right, because, like I said, the EVM is the regulations." - David Hoffman

Regulatory Actions

  • Initial strategy was to block on-ramps

  • Next might be to block governance

  • Regulators did not like what was happening in Electronic Market Era 1.0; similarly, they do not like what is happening in 3.0

Number of Centralized Exchanges

  • RegNMS killed off a lot of stock exchanges and forced consolidation in the sector

  • However, in crypto, this is much harder to pull off as each centralized exchange has its own standard, type of assets available, and level of liquidity

  • Hard to arbitrage between centralized exchanges (e.g. people who want to arbitrage between the Thai Bitcoin Exchange and the US Bitcoin Exchange need access to the Thai Baht and a Thai bank account)

Any Big Risk For Crypto On The Horizon?

  • Composability is a double-edged sword. It increases capital efficiency but compounds risk as people move through different protocols

Quantifying Risk

  • "Which is riskier? aDAI or cDAI?"

  • Risk is not static. It is always changing based on user behaviour in the system

  • During his time in HFT, he would run simulations of their strategy as well as the strategies of other market participants. The aim is to find out how often their strategy win against others by modeling the behaviours of market participants. This is similar to what they do in crypto markets

Protection From Systemic Risks

  • Compared to Eras 1.0 and 2.0, Era 3.0 is different from them as there is more transparency in the system

  • This transparency allows market participants to better assess risk and protect themselves

Preparing Ourselves For The Rest Of Era 3.0

  • Think about what primitives will get invented. They could be even further out on the risk scale, attract a lot of capital, and potentially crash

  • CeFi entities becoming frontends to DeFi as their businesses are not viable due to regulations

Era 3.0 at a glance

All information presented above is for educational purposes only and should not be taken as investment advice. Summaries are prepared by The Reading Ape. While reasonable efforts are made to provide accurate content, any errors in interpreting and summarizing the source material are ours alone. We disclaim any liability associated with the use of our content.