Market Design with Blockchain Technology

Katya Malinova  Andreas Park

source: coinschedule (data from Sept 5, 2018)

Initial Coin Offerings are now a reality

  • current world peer-to-peer -- through intermediaries

    • a dealer/market maker is on one side of trade

    • parties know who they are trading with

  • technology enables frictionless value transfer

1. Multiple Trading Protocols are possible

What is different?

  • See transactions between "addresses" (="IDs")

    • may be able to see frequent "traders"

What is different?

2. High Level of Transparency

you can tell if someone owns a lot

3. You can tell who owns what

What is different?

 Key: wallets/addresses = IDs  but NOT = traders

Informational environment changes drastically

Frictionless peer-to-peer trading

\(+\)

Research Question

How does the design of ledger transparency and identifier-usage with possible P2P interactions affect trading behavior and economic outcomes?

What is different?

Literature

  • Economics of blockchain protocols and transaction costs

    • there is a large literature in computer science, e.g., Eyal and Sirer (2014)

    • Gans and Halaburda (2015); and Halaburda and Gandel (2016)

    • Budish (2018), Saleh (2017), Biais, Bidiere, Bouvard, Casamatta (2018)

    • Huberman, Leshno, and Moallemi (2017), Easley, O'Hara, Basu (2018)

  • Smart contracts and other uses of blockchain

    • Cong and He [2017], Yermack (2017)

  • Blockchain and financial securities/markets

    • Boehm et al [2015]; Harvey [2016], Raskin and Yermack [2016; 2017]; Aune, Krellenstein, O’Hara, and Slama [2017]

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inefficient risk transfer

  • Data processing to contact small

  • Linear mining/validation cost

Model Ingredients

Direct Costs

Indirect Costs

  • Risky asset, normally distributed 

  • Two large investors, one hit by liquidity shock, repeated interactions

  • ​Continuum of small investors, half buys, half sells

  • Shocked "liquidity trader" (LT) may trade

    • peer-to-peer with other large

    • with many small

    • with risk-averse intermediary

Liquidity Providing peer may front-run Liquidity Trader

Requires a system design choice:

  • allow an entity (individual, investment fund) only a single ID per instrument

  • possible with private blockchain or ICO contracts.

Benchmark:
fully transparent (single ID) ownership

Trade with small investors and intermediary

Trade with the large liquidity provider ("LP")

  • costs:

    • complexity + validation

    • intermediation

  • costs

    • LT may get “front-run” by LP

​​

Repeated setting:

Front-running is punished by “grim trigger”

Single shot:
LP extracts all surplus

Options for the Large Liquidity Trader ("LT")

Equilibrium

  • "social norms" have bite: LT always trades with LP; share cost savings.

  • Price concession: none for frequent interactions (=large enough discount factor) 

Equilibrium

  • %IDs contacted independent of intermediary's inventories, but depends on:

    •  probability of small accepting

    •  (il-)liquidity of intermediated market

    •  complexity/data processing costs.

  • For non-large validation cost, LT trades with small (and intermediary)

Opaque single ID ownership

Closest and native to "public" blockchains:

  • anyone can participate anonymously

  • can create as many accounts as I want

  • described by Ethereum founder as simple solution to achieve privacy

  • private blockchains can choose to organize like this

Opaque multi-ID ownership

small traders

large trader

small traders

large trader

small traders

large trader

filled

unfilled


Opaque Single ID

Opaque Multi-ID: LP accepts

Opaque Multi-ID: LP rejects

Acceptance Probabilities in Opaque Settings

accept offer

"target" small investors only

  • price concession "wasted" on small

  • complexity costs:      high

  • intermediary costs:   low

  • no price concession

  • complexity costs:      low

  • intermediary costs:   high

"target" IDs of both: large and small

  • validation fees

Decision problem LT

Decision problem LP

front-run

Theorem: There exists an equilibrium with no front-running where:

  • LP accepts

  • price concession = 0

provided:

  • frequent interactions

  • or very liquid intermediated market (front running hard)

  • or high validation costs (front running expensive)

Result 2 (numerical): For infrequent interactions, the equilibrium with no front-running where LP accept does not exist. Then:

  • In equilibrium, LT offers p = 0 to the continuum, and

  • LP's IDs reject the offer.

=> "over-trading" with intermediary

  • Note: an increase in the validation cost may curb front-running.

Equilibrium & More

  1. ​Large traders do interact: 

    • welfare single ID \(<\) welfare multi-ID

    • payoff to large multi-ID (assume price=0) \(>\) payoff large single ID

  2. Large traders do not interact: 

    • welfare single ID \(=\) welfare multi-ID.

    • payoff to large with single ID  \(>\) payoff large multi-ID

  3. (Numerical) \(\exists\) parametric configurations with

    • large interact in multi-ID & p > 0 s.t.

      • payoff to large with single ID > payoff large multi-ID

Comparing designs

Observations

  • Intermediary involved \(\Rightarrow\) social inefficiency

  • Small with large traders \(\Rightarrow\) complexity costs

  • \(\Rightarrow\) Best if large interact 

  • payoffs under the full transparency highest by construction.

  1. Blockchain="Back office" tech with front office implications!

    • with peer-to-peer there are critical design choices

      • Who can see the ledger?

      • How are virtual identities managed?

  2. Findings:

    • Transparent ledger with single IDs is welfare optimal and has lowest wealth redistribution (almost by construction)

    • Between (A) public blockchain solution with multiple IDs and (B) private, non-transparent ledger with single IDs:

      • public blockchain privacy solution has higher aggregate welfare

      • but does not necessarily lead to higher payoffs for large investors.

Summary