DeFi is Fischer Black’s Efficient Market
The revolution shall be and, by all means, it shall be violent.
What improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable.
- Adam Smith
Fischer Black, a prominent American economist, and intellectual behind Black-Scholes mathematical model, theorized the upcoming changes to the means of structuring an exchange with the decent of automatization. He published his thoughts in 1971 in a two-part series titled “Toward A Fully Automated Stock Exchange”.
The series outlines Black’s views on what makes an efficient market possible, the role of the specialist (market maker) in such market, and transformations of market mechanics that would take place with the introduction of computing power.
With the genesis of cryptocurrency markets and, later, the decentralized finance sector, the criticism of the “traditional” settlement processes has risen as well. The hunger for the alternative has never been so avid. I’d like to draw parallels between Black’s suppositions and the phenomenon of decentralized finance (DeFi).
The Characteristics of an Efficient Market
1. Low Cost
The cost implies not the trading fee but rather market accessibility. The low barrier for entering the decentralized markets has been a major facilitator and reason for growth of the retail investment sector.
2. Continuous Trading
Opposite to traditional markets, decentralized assets are traded perpetually. There are no office hours, national holidays, or maintenance windows. The decentralized exchange (DEX) markets are available 24/7.
3. Fairness
The order filling engine should be structured in a way agnostic to the type of trader. Regardless of whether it is a large institution looking to hedge its risk or a retail trader seeking to open a position, the market ought to treat the participants uniformly. Equal access to liquidity means equal access to execute on asymmetric opportunities offered by the market.
The concept of market fairness is taken a step further with flash loans, the ability to gain access to (in)finite capital with no collateral requirements. With such a powerful tool, the market participant is able to realize a profit, which greatly exceeds the participant’s capital.
4. Random Price Movements
The price of a stock should follow a random walk.
Price retracement after a significant market move should be as equally probable as its continuation. Such moves are subject only to the changes in underlying fundamentals.
Technical analysts tend to engage in retrospective justification of the price action. This happens even more often in a highly volatile environment due to frequent market movements. Despite such sentiment and predictions, cryptocurrency markets are contingent and unattainable to market manipulators. The price shift in any direction is as likely as in the opposite under any conditions.
The Role of the Specialist
The specialist is, by design, a supply aggregator. The specialist’s book is an accumulation of liquidity for meeting market takers’ demand. As suggested by F. Black, in contrast to market and limit orders the investor would have an option of placing the “participating order” to supplement the specialist’s book. This is beneficial to both sides because the specialist obtains access to more liquidity and offsets the risk and the investor secures a fraction of the profit from the specialist’s market-making activities.
In the realities of decentralized finance, the specialist has morphed into an automated market maker (AMM). The specialist doesn’t have to be a human anymore, but rather a mathematical function that satisfies the market demand with available liquidity. The investor willing to engage in market-making action has evolved into the liquidity provider (LP) and their “participating order” — into an LP position.
DeFi is More Than Fischer Black’s Automated Stock Exchange
This is a letter of recognition. The technology has allowed for the market mechanics to evolve in ways that couldn’t be imagined half a century ago. The tools for underwriting liquidity, order matching, and the creation of financial instruments on the fly, which came to us with decentralized finance, are groundbreaking. With the equal opportunity of DeFi, the market participant can take on the role of the broker, market maker, or speculator, or all of the above simultaneously.
