Stock Exchanges are Ripe for Disruption

January 21, 2014

4 minute read

Tell me, why are stock exchanges still in business today? I honestly have no clue. The only reason I can see is so media outlets have a reference point for the general public. If you are a trader and executing your orders on the exchange, you know that you are getting the dregs. In other words, you are last in line.

Volume continues to leave the traditional stock exchange. Last year when $ICE bought $NYX, it wasn’t for the stock exchange. It was for the futures exchange they owned. Government regulation has made the role of the stock exchange meaningless. The real money is made behind closed doors in private dark pools. That’s where the market is priced. The general public isn’t allowed behind those closed doors. Only the hedge funds and investment banks are given “speakeasy” access.

The stock exchanges also have lost their way and abandoned core values. The primary function of a stock exchange was to raise capital for growth. The exchange was a centralized marketplace where price was discovered competitively by buyers, sellers, and risk takers. If there was a hint of a capitalistic society, the stock exchange formed. Amsterdam had one, and much of the exploration of the New World was financed through it. Companies would list their equity, and buyers would exchange currency for equity because they thought they would get a higher future return from holding equity over cash. It would be more efficient for companies to exchange equity directly for assets that they needed for growth-because it eliminates the middlemen in the stock market. But, because centralized exchanges were so efficient, corporations are okay paying for that efficiency.

Exchanges and investment banks have successfully lobbied for rules, and put personnel in agencies that regulate them. The result is a highly expensive moat to cross, with expensive barriers to entry.

Today, there are developments that could totally disrupt centralized marketplaces. Bitcoin isn’t just a medium of exchange. It’s also a transparent online general ledger. It is not just those two things, it’s also an internet protocol that closes loops and plugs holes in the internet.

Imagine if General Electric ($GE) could issue it’s own currency to purchase growth assets. That’s what Bitcoin as an internet protocol could enable. Decentralized exchanges, and decentralized currency markets.

If exchanges aren’t being active participants in the development of Bitcoin, they risk being put out of business.

One of the main aims of the Open Transactions project is to decentralize the entire financial landscape by allowing anyone to issue currencies and various financial assets that are secured with cryptography. Anyone will be able to create digital tokens that represent real value on Open Transactions, but one of the most innovative features of this system is that the people who issue the digital tokens will not be able to alter the ledger for their currency or stock. For example, PayPal can technically go into their servers and change your account balance from $11,873.33 to $4,902.34 if they felt compelled to do that. This kind of action is impossible with assets issued through Open Transactions because of the way that the transactions are handled and signed. Of course, there is still the problem of having to trust that a third party who is backing their currency by gold, silver, dollars, or any other asset actually has the asset in a vault somewhere. The good news is that a solution for this problem has recently been found. In addition to issuing a currency, an issuer can also store collateral for the users of his or her currency in the form of bitcoins. For example, if there was a currency that was backed by one ounce of gold, then the issuer of that currency could send an ounce of gold’s worth of bitcoins into an escrow account and agree to distribute those bitcoins to the holders of that particular currency in a situation where there is a “run on the bank”.

One of the essential backbone features of exchanges is the back office which processes trades. It is entirely possible that this core function is not important when Bitcoin software platforms get developed and adopted. Futures exchanges use their clearinghouse as a competitive edge. That edge could be eliminated with Bitcoin, because there are zero transaction costs.

One of the things I have been watching closely is the way Bitcoin has developed as a medium of exchange. Because of volatility, it’s not a store of value-and there is high risk in holding Bitcoin. One remedy I thought of was an exchange clearinghouse model. The clearinghouse assumes the counterparty risk, and charges a fee for the assumption of that risk. But, Bitcoin developers might have found a way around that risk with the transparent ledger.

If there isn’t counterparty risk, the only risk left to hedge is price risk. That doesn’t need to be done at a centralized exchange.

We are just beginning to trod down the path and it’s very early days. Right now, it’s more important to ask “why not?” than “why?”.