Blockchain technology brings innovation, and the very nature of this innovation is often lost in public debates—arguments centered on negative perceptions of blockchain. We examine where and why blockchain will challenge traditional financial services.
As an example, we show Uniswap’s decentralized exchange platform and compare it to traditional exchanges, including crypto exchanges and stock exchanges. Uniswap can offer consumers 20 times lower costs than traditional competitors thanks to new smart contract business models that improve efficiency. Uniswap’s openness and transparency also ensure a fairer market, with less room for harmful business practices.
Recently, there has been talk of blockchain not solving any real problems. Recently, renowned computer scientist David SH Rosenthal gave a speech in which he criticized blockchains and explained why he does not believe they (blockchains) can create value. Many influential technologists have embraced this view, such as Microsoft Cloud Services CTO Mark Russinovich, and while some of the criticisms raised are valid, they focus on blockchain technology areas of weakness, only built on the history of cryptocurrencies. These smart people are experts in their fields, but they may not study the latest engineering results or the state of contemporary encryption, consensus, and fintech solutions.
These arguments may have been correct repeated arguments a few years ago, but are debunked today:
1. Energy consumption: Of the top 20 tokens by market cap, only one uses an energy-sensitive proof-of-work consensus (Ethereum merger will transition the chain to proof-of-stake in summer 2022).
2. Terrorist and Criminal Use: Based on facts and figures, this is a politically exaggerated issue, as seen in the 2022 National Cryptocurrency Crime and National Money Laundering Risk Assessment.
3. Speculative risk in cryptocurrency investing: Not unlike Nasdaq stock volatility, with tech stocks down 75% from their all-time highs, stablecoins are a medium of value transfer in any case.
These arguments fail to take into account the use cases for blockchain to create value for users, and it would be irrational to dismiss blockchain technology altogether. Fundamental value is created, and this value creation is difficult to replicate in traditional business models, and we have seen what kind of measurable and tangible benefits blockchains provide to their users.
Markets are reported to be operationally efficient when participants are able to execute transactions and obtain services at prices comparable to the actual costs required to provide the services. When transaction costs are reduced, an economy becomes more efficient, and more capital and labor are released to create wealth.
Transaction costs, or general fees here, have nothing to do with the asset itself that you pay for the trading platform. This principle applies to both liquid markets (stocks, cryptocurrencies) as well as illiquid, non-fungible markets (real estate, NFTs).
Expenses can be defined as:
Spread – The difference between the best buy and sell.
The fee charged to the market maker (usually related to the above).
Fees (commissions) charged by trading platform operators.
Fees paid to infrastructure providers.
Other fees and non-transaction fees, such as withdrawal fees and account opening fees.
NYSE historical transaction costs
In addition to fees, we have a price impact, which is a result of available liquidity. The greater the liquidity, the less impact on the price. The price impact has nothing to do with fees – it’s more a result of market size than operational efficiency itself.
Liquid market fees are usually measured in basis points (BPS). A basis point is 0.5%. While each order can have a fixed price, in more liquid markets the transaction price is usually just its BPS fee. For example, a transaction of £500 has a handling fee of £3, which is equivalent to 500*0.0003=£0.15.
Here are two screenshots of the PayPal stock online broker. You can see that the brokers are giving you different buy and sell prices. The difference is the difference. The spread for PYPL is 1 – (112.20/ 112.31) * 10,000 = ~9.8 BPS. Even though the transaction is “0% commission”, the user ends up paying for participation in the form of a spread loss. If you are buying or selling, you need to pay 5 basis points above the theoretical midpoint.
Uniswap: the most efficient trading market in the world
Uniswap v3 is the third version of an automated market maker that now provides centralized (scoped) liquidity supply. Uniswap is available on public blockchains based on the Ethereum Virtual Machine (EVM), including Ethereum mainnet, Arirum, Polygon, optimizationPBC.
Unlike decentralized, order-based bidding, Uniswap introduces the concept of scoped liquidity, also known as centralized liquidity. In a scoped liquidity model, liquidity providers (equivalent to market makers) supply both buyers and sellers of assets. Below is a range chart for the ETH-USDC 5BPS market:
USDC-ETH liquidity distribution on Ethereum mainnet Uniswap v3
In a range-based liquidity model, the spread on a trade, or so-called “swap,” is zero, and any fees on the trade go directly to the liquidity provider. While it is possible to charge commissions on the trading platform itself, Uniswap has not done so. Uniswap’s closest competitor, Sushiswap, charges its token holders a 16% liquidity provider markup.
Initially Uniswap v3 supports fee markets of 5, 30, 100 BPS. After launch, activist investors Alex Kroeger and Getty Hill proposed a 1 basis point market as a successful demonstration of decentralized protocol governance using Token. Currently, the 1 basis point market only applies to non-volatile assets such as stablecoins, similar to traditional financial foreign exchange markets. Still, their very existence suggests that a race to the bottom is underway.
Top Uniswap v3 pools where you can find 1 BPS, 3 5 BPS and 30 BPS pools
method of comparison
To demonstrate the efficiency of Uniswap’s market operations, we compared it with state-of-the-art trading platforms and brokers. This is by no means a scientific study, we illustrate our point by comparing prices over a 24 hour period.
We compare the Uniswap:ETH-USDC trading pair market with Binance and Coinbase, the world’s leading centralized cryptocurrency exchanges. We also liken it to eToro, CFDS, the “free” online broker on the NYSE stock market. We also compare it to the traditional small broker Nordnet and its broking of stocks listed on Nasdaq Helsinki.
No discounts are given or accepted
This comparison is made from the perspective of a “retail” trader – assuming a price-unaffected trade of $1,000. We do not take into account all discounts, rebates, etc. for large dealers or those who have a direct seat on the securities trading platform. We also consider withdrawal fees, and we also assume market order (take order) type as this is a typical transaction for retail investors.
stock market comparison
Nordnet and eToro select the best samples of bids and bids from their respective web user interfaces at 16:33 local time for spread measurement. We also include EUR/USD conversion fees charged by online brokers on deposits and withdrawals. In the cryptocurrency market, the corresponding fee will be the EUR/USDC transaction cost on any order book.
For further comparison, we included Nordnet’s “unlisted stock” price and then randomly selected a small-cap token from the Uniswap list to better understand AMM pricing for illiquid assets. But for illiquid assets, where price effects are the dominant factor, transaction fees are insignificant.
Below is a screenshot of the Coingecko ETH-USDC market page, taken from March 11, 2022, which we use as one of our data sources.
We also measured the spread on eToro’s eth-dollar pair. eToro (Europe) Limited is an EU financial services company authorized and regulated by the Cyprus Securities and Exchange Commission (CySEC). eToro is not a cryptocurrency trading platform, but still provides cryptocurrency brokerage services. The eToro spread is 200 basis points, or 2%. On this EU-regulated “zero-fee” broker, you end up paying 20 times more than a decentralized exchange and around 4 times more than its U.S. competitor, Coinbase.
eToro screenshot snapshot taken from the eToro user interface
blockchain transaction costs
For blockchain transactions, costs are paid to block producers (called “gas fees” in Ethereum negotiations). Since there is no good service to compare transaction costs across the blockchain, we obtained data on the lowest transaction fees from l2fees.info. Note that this does not reflect current proof-of-work transaction fees on the Ethereum mainnet, but presents the most easily verifiable on-chain costs. Popular layer 1 chains such as Avalanche and Polygon align with ZKSync gas fees. A non-evm blockchain like Solana could further reduce costs by a factor of 10.
Transaction costs for Ethereum L2
For comparison, we gathered information on the source of the fee below:
Coinbase Pro Fees
Results of the comparison
Uniswap is the most cost-effective ETH-USD market for retail traders, assuming free USDC/USD fiat in and out channels via Circle or Coinbase.
Uniswap ETH-USDC beats the best cryptocurrency exchanges with a transaction cost of around 5 BPS, also in line with online stock brokers. From the screenshot above by Coingecko, we can see that Uniswap has the second highest trading volume, which is up to 50% of the comparable Binance ETH/USDT. Therefore, it can be said that the market has realized the efficiency of the decentralized market.
Uniswap’s 5 bps total fee is comparable to eToro’s 10 bps spread on “no-cost” liquid stocks. Uniswap has no withdrawal and deposit fees, so its total transaction costs may now be lower.
We also add some other costs that are not immediately visible in the spread or trade commission.
Efficiency factors beyond transaction costs
Additionally, because Uniswap runs on a public blockchain, there are some efficiencies that centralized markets cannot match.
- No counterparty risk.
- There are no withdrawal or deposit fees.
- Direct to investors or no brokerage fees.
- The market is running all day.
- Thanks to the use of a public blockchain, data is freely available to all at the same time, making the market fairer and there are no hidden costs of delayed market data.
- The software that runs the trading platform is open source, and anyone can audit errors in fee structures and more. Since market participants can self-audit their premises, less regulatory intervention is required.
- No vendor lock-in. If you are not satisfied with this service, you can take your tokens to any other exchange with almost no fees and no hassle.
- The listing process is automated. For asset issuers, the cost of listing is essentially zero, both in terms of cost and time.
- Fewer staff required: Since activities are managed by smart contracts, there is less need for front, middle or back office staff (finance).
Why can public blockchains solve transaction problems more efficiently?
Uniswap, an improved centralized proprietary solution, is a great example of blockchain technology, and it’s important to ask the question: “Why is this possible?”
Opponents of blockchain technology often argue that anything implemented on a blockchain can be implemented more efficiently on private servers, such as on the Microsoft Azure cloud. Maybe — if you only count the electricity bill for one server. In practice, electricity costs are not a significant cost for any software-as-a-service business, and business costs are created elsewhere.
We believe that blockchain technology has inherent advantages that have long been unmatched by proprietary solutions and business models.
Creating efficiencies through openness and transparency, public blockchains rely on three cornerstones:
1. Open source: Blockchain and decentralized finance protocols are open source.
2. Open Data: Data is freely available to everyone.
3. Open network: There are no barriers to entry for transactions.
We examine how these ideas have historically worked individually and then conclude why combining them yields new benefits.
The benefits of open source
The open source software movement started in the 1980s as a branch of the free software movement. A key promise of open source is that software can be created more cost-effectively due to collaboration and reusability. Compared to proprietary software development, open source promises no vendor lock-in costs, larger talent pool, better career paths, better developer motivation, easier adoption, less licensing hassles, guaranteed software continuity Wait.
The sweet spot of open source and its more general counterpart, open innovation, is that SMEs can innovate and collaborate together to compete with larger corporations.
A16z talks about why open source should swallow traditional financial software
The most famous open source success story is the Linux kernel, which began with the hacking movement in 1991 and developed into a mainstream server-side operating system in the early 2000s. It’s an uphill battle: the contempt, perfunctory, and muddled waters of Linux by a big company like Microsoft. It might buy some time, but in the end, it’s futile. First, Linux bankrupted all commercial unix systems (HP, Sun, IBM AIX). In the end, Linux gave Microsoft a break in the mobile operating system market. Phone makers trust open source Android over Windows phones because they have more control over the ecosystem. In the end, Microsoft wrote off the $7 billion mobile phone business, a pretty big win for the “communist thief.”
Linux as the foundation of the software business led to the birth of Google, Android, and Tesla. Today, Linux powers billions of devices. But more importantly, Linux is a core component of thousands of products and businesses. Due to the nature of open source, these companies can co-innovate collaborations that they otherwise couldn’t.
The benefits of open data
While data has existed since the time it was written, the accessibility of data provided by the Internet has increased the impact of open data by orders of magnitude.
Data sharing is an interoperable software and hardware platform that aggregates (or collocates) data, data infrastructure, and data production and management applications to better allow user communities on short- and long-term timelines (Wikipedia) Manage, analyze and share data with others.
Open data drives innovation, and, as we discussed earlier, proprietary data leads to market inefficiencies and oligopolistic profits.
The main political and socioeconomic drivers of the open data movement by Maxat Kassen
Blockchain takes this to another level using anonymous addresses and public key cryptography, with innovations that separate real-world identity from ownership and authorization. Without this separation, data can become a burden and be subject to complex or impossible licensing arrangements. Because there is no such liability, parties can more easily transact with each other because they don’t need to worry about what happens to their private information.
The benefits of an open web
In the early 1990s, the Hypertext Transfer Protocol (HTTP) kicked off a boom in the Internet “information superhighway” that subsequently led to the creation of e-commerce, online banking, social media, and remote working industries. The main driver of internet adoption is its openness – anyone is free to set up their own web server, home page or online store without the need for permission. While some of the same original ingredients already existed in licensed networks in the 90s, such as the Microsoft Network, the Internet quickly took over. Public blockchains bring the permissionless model of the internet to financial services, making barriers to entry very low.
To transact with a public blockchain, you pay a fee in the form of transaction cost, which is roughly equal to the actual cost of the transaction contained in the ledger, or the unit of computation consumed by a blockchain node. The experience is frictionless: no software licenses to buy, no business negotiations, no paper agreements to be emailed back and forth, no API keys to generate, and no marketing spam to accept. This makes transactions on public blockchains the ultimate process improvement in the financial sector.
This table shows the process efficiencies of paper/bricks-and-mortar car sales versus internet sales, one of the early studies of the internet’s impact on business. In a similar fashion, public blockchains further improve efficiency by streamlining processes by encrypting transactions, public ledgers, and reducing software and organizational costs.
In theory, traditional financial systems can become open networks and match the model set by public blockchains. But in reality, they can’t. Traditional finance is built on a network of high trust because:
Control : Make sure profits are kept in a closed circle, fearing competition.
Lack of system resilience: Malicious actors can compromise the system.
For example, direct API access to the stock market order book is carefully cultivated to be available only to certain members of a securities trading platform, while everyone else needs to go through a broker who acts as a middleman. This is because trading orders are still traditionally settled through a hierarchical network of middlemen, but also because securities trading platforms can make more money by retaining gated access to certain participants.
Another example is the EU’s PSD2 directive. Banks have a huge moat because they hold people’s money, but the only way to get that money is the way the bank tells you to – through their (often scary) online portal. There were no APIs back then, and you couldn’t create an app that spent money or transacted from a bank account. It’s about controlling and managing competition for banks: they worry about others creating better products and turning banks into useless channels.
The EU likes competition, arguing that banks’ sticky customer moats hinder innovation. Subsequently, the EU tried to enforce the “must provide API access” principle through the Payment Service Directive 2, hoping to stimulate some competition. But the law doesn’t produce effective software – implementation is fragile and faces conflicts and challenges. Its implementation itself is not open – TPPs (third-party providers) still need permission to access any incompatible APIs. Or to put it bluntly: the PSD2 model is a bit contradictory, you need to contract with a third party to gain API access to your own bank account. PSD2 has not been a huge success or spurred the fintech innovation touted by its political promoters.
Who is decentralized?
New technologies like public blockchains are disruptive innovations. The benefits they promise come from “disintermediation” — removing middlemen from the process and replacing them with software and automation. So, in the case of a decentralized market, who exactly is being replaced?
Revenue and profitability of stock and crypto trading platforms on MarketWatch
If we look at the trading platform fees we discussed earlier, we can see that the trading platforms are charging commissions in the form of spreads and fees. These funds are then further distributed among the exchanges themselves (Coinbase, Binance) and their market makers (internal, third parties), usually in the form of rebates paid through opaque arrangements. Market maker arrangements are based on trust or volume – an ordinary layman can never get the same trades as a “designated market maker”. Perhaps the most dubious form of these trades comes from the public stock market, from the free online broker Robin Hood and its payment for order flow (PFOF), as brokers make more profits while “saving their clients’ transaction fees” (earned spreads, not fees).
In a decentralized marketplace, such mischief does not exist. Anyone can become a market maker on Uniswap, or they are called liquidity providers. Everyone has the same terms of entry into the market. If there are special proposals among people, they need to go through a public governance vote and they will be visible on-chain. This forces the market to become fairer and more competitive. Additionally, direct-to-investor trading platforms eliminate the need for brokers, and self-custody eliminates and reduces the need for custodians compared to the traditional financial world.
Uniswap liquidity provider profitability research
Cryptocurrency trading platforms enjoy lucrative profit margins in 2021. But this is changing as the share of decentralized exchanges continues to grow. Naturally, market makers are skeptical of this progress. Even though Uniswap’s remote liquidity model is new, yet to be validated, and data is still being collected, it appears that market makers can remain profitable, but with lower margins. This ultimately means less profit for trading platforms and market makers, which translates directly to less fees for consumers.
Decentralized Finance Issues
Financial decentralization didn’t really start until the summer of 2020, the so-called DeFi summer. Before that, blockchain technology was too primitive. It took years for Ethereum’s software development tools to reach the level of maturity that led to the creation of protocols like the Uniswap we see today. It’s similar to what happened with Web 2: Facebook took 15 years to develop a web browser to launch.
We’re dealing with a very young phenomenon, and it’s not a problem without it. The biggest problem is that users need some time to learn the new technology. While there are some new concepts to learn, like wallets, the user experience may never be the same as centralized online services, but internet users have gone through similar transitions before: learning email, learning smartphones, learning social media.
Because users are still somewhat ignorant about blockchain technology, they are vulnerable to scams, both technical and investment. However, as users continue to learn, this phase will gradually pass.
It took 10 years for Linux to go from academic application to mainstream operating system, and then another 10 years to become the king of operating systems. This means disruption to existing industry players (Microsoft, IBM, Sun), but in the end, it leads to better services for consumers (Android phones, cloud servers).
A similar revolution is taking place 10 years after Bitcoin, as open source is making its way into financial services. Public blockchains and decentralized exchanges are at the heart of this movement. The underlying reason why they won’t succeed doesn’t exist. Regulators and the public are concerned; this is both out of genuine concern, sometimes because of lack of information and misunderstanding, and sometimes simply because of a natural resistance to new phenomena.
Competition doesn’t appear to be eroding the industry’s huge profits, and in fact there is some evidence that consolidation in the financial industry is leading to more fees and poorer customer service.
However, this change is necessary. While providing transactional services is a race to the bottom, this competition can have unintended consequences for service users. It would be better to build an ecosystem where service users have a greater say in matters and even the smallest players can easily collaborate. Promoting a movement that emphasizes transparency and fairness could well offset these concerns, reducing regulatory intervention to keep the game fair. This is exactly what decentralized finance does in the long run.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/opinion-why-the-worlds-most-efficient-market-runs-on-the-blockchain/
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