Financial markets are enormously important in today’s societies, yet many of us don’t know or care how they ‘work’ — they’re just something that chugs along in the background.
This Loopring Learning Series is meant to act as a basic primer of economic concepts related to the protocol, but also to financial markets in general.
Financial markets are just that — markets —‘places’ where a buyer and seller meet up to trade some asset. They agree on a price that satisfies them, and they execute the transaction.
How exactly these buyers and sellers meet up, communicate, and consummate trades is what we’ll explore in this article.
In general, there are two ways that markets for financial securities are structured: Exchange, and Over-the-Counter (OTC).
Exchanges are what most people think about when they hear ‘financial markets’. They think about the physical trading pits where people are yelling to get stock orders heard. These days, however, physical exchanges are dwindling as the action moves online, and exchanges such as Nasdaq are completely electronic, resembling tech companies more than financial firms.
An exchange is a centralized entity that works by aggregating orders from buyers and sellers around a particular asset; be it Gold, Bitcoin, Google stock, or LRC tokens. Although you are trading against other people’s opposing orders, the counterparty is the exchange itself, as they’re the one that’s doing the matching and execution. Exchanges allow for ‘multilateral exchange’, meaning anyone can trade vs anyone else, but all through one exchange (or more aptly, its software).
Exchanges match trades by using a matching engine — algorithms that match bids and offers by some set of rules. The most common type of matching algorithm is price-time priority, which matches opposite sides of an asset by price, and then time.
For example, if you want to sell (offer) BTC for $7,025, you are in line with all other sellers offering their BTC for $7,025. Take a number and wait in line. When it is your turn, and a buyer on the other side of the market wants to buy BTC for $7,025, the trade executes.
What we see above is called an order book; it’s how an exchange aggregates and displays orders. It represents the collective market’s intentions (thoughts) on the asset, and are the inputs for the matching engine.
[We’ll talk about limit vs market orders, and maker-taker in another article.]
Whereas the stocks we’re all familiar with trade on exchanges like NYSE and Nasdaq (as do most cryptocurrencies trade on centralized exchanges like Binance), there are many financial securities that do not trade on exchanges. FX (traditional currencies) and most types of fixed income assets trade Over-the-Counter (OTC).
OTC trading happens through a decentralized network of dealers — entities whose business it is to ‘make a market’ in these securities, and facilitate trades for clients. Dealers can trade with clients from their own ‘book’ of assets (known as trading as principal), or by connecting an opposing client trade (known as trading as agent).
These dealers, or, market makers, quote a bid and offer for given financial security. They essentially hang a sign on their door that says I will bid $6,950 per BTC, and I will offer it at $7,050 per BTC. The dealer will also specify what amount of Bitcoin these prices are good for (i.e. 1 or 10,000 BTC). Of course, they update this ‘sign’ and their quotes as frequently as they like as the market moves and things change.
Like this, traders can call the dealer on the phone and say, for example, “I will sell you 3.86 Bitcoins at $6,950”. [In fact, it is still very telephone-based for OTC markets like FX and bonds].
Thus the dealer is providing a service to clients and the specific market itself by providing liquidity and facilitating trades. Importantly, the dealer faces risks by doing this; what if right after the dealer bought the above 3.86 BTC, the price crashes to $4,000?
This risk is why the dealer has a bid lower than the offer; this spread is a market maker’s protection. In the above case, it’s a $100 spread for BTC. The dealer will make this spread by trading with clients both ways. This is how the dealer makes money; by (trying to) sell high and buy low.
Of course, the spread is not infallible: the market could move violently one way and the dealer may be dramatically exposed. Spreads are different for different securities; the more liquidity there is — with higher volume and people trading back and forth — the tighter the spread.
Dealers don’t only trade with clients, but also with other dealers. Dealer-to-dealer trades help them balance their own exposures from trading with clients in the first place, and provide greater liquidity to the market. These trades can be done by dealers calling each other up and asking for quotes, or by using inter-dealer brokers, whose job it is to connect and facilitate trades among dealers.
Whereas exchanges host the order book for everyone to see, OTC markets are not required to display their info publicly, and trades happen bilaterally — between two parties speaking directly with each other. Dealers can make their bid and offer quotes known via an arbitrary method such as phone, email, their website, etc. In practice, lots of traditional financial market relationships and trade evolves on platforms like Bloomberg Chat.
In the bond market, for example, a dealer will send ‘runs’ to their clients: an electronic list of bonds they are making a market in, and the corresponding bids and offers at which they’re willing to buy or sell these securities. In this sense, the OTC markets are much more private as negotiation and execution is done between specific parties ‘behind closed doors’. The execution and price of trade need not be shown to anyone else. Thus, relationships matter and dealers can discriminate prices for ‘good or bad’ clients.
In OTC markets, a client’s counterparty is the dealer and vice versa. This means both parties face the risk that the other may not deliver their end of the deal, or just go bankrupt. For this reason, too, relationships and trust matters.
Blurred Lines and Differences
Electronic trading platforms have begun to pervade the relationship-based OTC markets and make them more closely resemble the exchange model. The result is that hybrid systems of OTC/Exchange are taking shape.
A common critique of OTC markets is that the lack of transparency can pose risks for clients, as well as counterparty risk being an ever-present threat. Further, when times get tough, dealers can simply withdraw from making a market in some securities as the action is too volatile. When this happens, clients in an OTC market may not be able to sell their assets at all, and this illiquidity leads to greater fear and lower prices in a vicious circle.
On the other hand, given that OTC markets have many different dealers competing for client business, there is more likely to be reasonable fees and service levels since clients can just go to the next dealer if not satisfied. Dealers will compete on price and service to keep clients. This stands in contrast to exchange markets where, if you’re unhappy with prices or fees, there may not be viable alternatives.
Loopring — a decentralized exchange protocol
The Loopring protocol allows anyone to build decentralized exchanges for tokens, or more generally, value. Now, although it has ‘exchange’ in this description, the Loopring model actually draws much of its inspiration from the OTC model: it works by connecting a bunch of ‘broker-dealers’ (called relays) who interact with clients and with each other.
However, these dealers (relays) don’t need to make a market (and take the corresponding risk), but can simply communicate and match opposing client orders (acting as an agent, not principal). By connecting relays in a way that promotes cooperation, liquidity is never stuck in silos, and traditional OTC troubles of illiquidity at stressful times is reduced.
Furthermore, instead of clients having the risk that a dealer/relay will not hold up its end of the deal, Loopring moves any counterparty concerns to public smart contracts, eliminating the need to trust any person or entity at all.
It may be helpful to think of Loopring as a half (decentralized) exchange, half OTC market. In essence, it allows for many OTC markets to be built by different participants ‘along its rails’, and then connects them, making these OTC markets function as a unified exchange network.
This was the first post of a series on general financial market concepts. If you’d like a specific topic to be explored, please reach out or say so in the comments.