Streetwise Professor

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.