The following is a crude, first attempt to try and define a way for an online market to operate that is entirely decentralized (i.e. there is no central exchange).

In addition to describing some of the mechanisms that would allow such a market to operate, I am also calling for a) the establishment of a foundation or industry association to ensure that standards are created for the necessary systems, and b) the voluntary acceptance of some level of regulation (i.e. government) by the virtual market community. I’ll make cases for both below.

I’m interested in hearing feedback. If there’s sufficient interest I’ll set up a wiki and try to get a community together.

Please note that I haven’t yet put in links and footnotes – this will be revised periodically as I find time to put that info in.

1. Overall description and necessity

There are existing efforts to build a variety of different kinds of web-based virtual markets, including currency exchanges, equities (i.e. stocks) and options.

These markets are frequently highly illiquid, poorly constructed (at a technical level, from a transparency standpoint, and at a marketing level), and suffer from extreme levels of volatility. The recent “virtual correction” in the exchange rate for BitCoins is a case in point.

The original efforts to build virtual currencies often were based on a philosophical view that decentralization and transparency would resolve many of the issues in “real world” markets; this has been undermined by the ongoing necessity of centralized markets.

There are existing plans to decentralize virtual currency exchanges – the following is an attempt to generalize this to any kind of virtual market.

2. Digital wallets, equity encoding and price information

Every user of a decentralized exchange will need to have a form of digital wallet to store information about their own holdings.

This would work in a similar fashion to a number of existing digital wallets (one example being BitCoin), but would, in addition, need to have logic for negotiating the exchange process with various intermediary parties.

It will also need to have user-adjustable privacy levels to allow for optional reporting of trade information (or even existing holdings) to the rest of the network.

As well, the wallet will need to be able to handle a wide variety of types of equity, including some complex items such as options.

The wallet may thus have fairly significant data storage requirements, particularly if it is storing information about “nearby” trades.

The process of backing up wallet information should also be far more transparent to end users than existing digital wallets. If this market is to be successful, the volume of trades and amount of total equity will be very large – too big to allow for the failure of a single computer. Information either needs to be replicated among wallets in a peer-to-peer manner, or there will need to be a role for third-party back-up services on a commoditized basis.

3. Standardized escrows, trust metrics and commissions

In “real world” markets, the broker is a key part of the exchange mechanism. They serve a variety of necessary intermediary roles in order for buy/sell operations to occur, including the process of actually negotiating the sales, the clearing process, and enforcing exchange rules such are margins.

In a peer-to-peer market, the role of a broker is taken on by escrow services. Without an escrow, there is a serious trust deficiency, in the sense that a buyer and seller need to have a high degree of confidence that a sale will conclude normally, without any way of knowing who the buyer and seller(s) (i.e. for dark pools to operate) are. If the peer-to-peer market is to operate anonymously, there is no easy way for a trust metric to be established for the individual traders. Instead, a standardized method of negotiating escrow is required.

The way the escrow system will work needs to be roughly along these lines:

• There will be a standardized API for how escrows on the market will operate with software.
• Escrows essentially become a commodity service – they will publish their transaction rates in a way that can be discovered automatically.
• The market will maintain a trust metric for individual escrows, based on the completion of sales (i.e. sales that are cancelled by buyer or seller before completion should not weigh on an escrow’s trust ratio).
• An individual trader can create their own list of escrows that they do not wish to use; otherwise the process of selecting an escrow should be completely transparent, based on trust metric and the escrow’s published commission rate.
• Since there will always be at least two escrows (and in many cases far more) involved in any sale, there will need to be a standardized method of dividing up any commissions involved, and parceling them out.
• The buy/sell mechanism will be described in detail below.
• In order for complex transactions to occur (i.e. short selling, options etc), escrows may need to have minimum capital requirements, and may also wish to enforce such requirements on traders using their service – this will need to be part of the automated negotiation process.
• It isn’t clear at all how commodity trades would operate on this type of system – certainly there would need to be a mechanism for the delivery of commodities, and this might be fulfilled by escrow operators.

The distributed buy/sell mechanism will work something like this:

• A trader places an order (buy or sell) within their wallet
• The peer-to-peer software will try to find matching orders
• If an exact match is not found, a series of partial matches may need to be made through one or more discovery services, dark pool operators or market makers (these roles will need to be standardized through APIs, and may or may not be run by different organizations; they will, however, be designed to be commoditized, in the sense that there will be many of them that are essentially identical from the standpoint of the trader).
• Once the matches are found, the trader’s software will negotiate a contract with an escrow; each of the traders in the transaction will separately do so with their own escrows. The information on which escrows are involved will be exchanged through the system.
• The contracts with the escrows will also include privacy setting information from the wallets – i.e. some users may not allow the publication of the final price, or even the fact that a trade occurred, whereas others may not mind.
• The escrows will then negotiate commission splits between each other, and handle the collection of the relevant equities, their exchange, and their return to the relevant party’s wallets.
• The wallets would then publish updates to the escrows’ trust metrics.
• This process will need to be tweaked in order to ensure anonymity, and ease of order matching.

4. Price discovery

As mentioned above, there are roles in this market for operators of dark pools, market makers and price discovery services. It isn’t clear to what extent it is possible for these roles to be completely decentralized.

In a peer-to-peer market, information about completed trades would generally be stored in the wallets of the traders, who may not necessarily be online at any given time, and who may wish to use different privacy levels in terms of sharing information. There needs to be some type of mechanism for sharing information about pricing, and this may take the role of multiple organizations that collect, collate and publish this information (possibly for a small transactional price). It is also clear that some of the information that is available in “real world” markets may not exist in a decentralized one – some trades may not be reported due to privacy settings etc. There needs to be some discussion regarding how price discovery would operate in this situation.

5. Regulation

Online, virtual markets are coming, whether we (or governments) like it or not. There’s a good chance that they will be decentralized in the way I am describing, if for no other reason than to minimize outside interference and reduce transaction costs. It is absolutely clear that ground rules need to be set, and if the technical community doesn’t do it, governments will – even if their only resort is end-user prosecution.

In “real world” markets, government regulation serves to prevent abuses such as insider trading, front running, parking and the like. While some of those kinds of abuses are not feasible in a virtual market (i.e. a broker would probably not be able to front run a peer-to-peer market order), and it would be almost impossible to force-ably regulate a decentralized market, I believe that there are several reasons why such regulation should be voluntarily accepted:

• In order for virtual markets to be successful, there will ultimately be a need for high quality equities. The only BitCoin stock exchange that I know of right now currently has two trading equities, both with market capitalization under $1000. It isn’t clear to me why any sensible investor would want to trade on such stocks; chances are that all of the current trades are by insiders of one stripe or another. A large cap company simply will not trade on such a market, since it has to operate in a number of countries that will penalize it for doing so. By regulating virtual markets, we open the doors for such equities to be traded.
• The existing virtual markets are extremely opaque; without some way to prevent insider trading, there is no way that investors (as opposed to small-scale speculators) will trade. These markets will not be successful until they can attract larger investors. In addition, many institutional investors will not be allowed by their own internal policies to trade on unregulated markets.
• By voluntarily accepting sensible regulation, we avoid the situation where regulation is set by those who don’t necessarily understand how these markets work.

It isn’t clear who the governing body for such regulation would be. Virtual markets operate in every country, and around the clock. As a result, enforcement will require participation of many polities, including many with little knowledge or understanding of how virtual markets work.

I believe that the first step will be the creation of an industry group or not-for-profit foundation that will a) assist in establishing guidelines, b) coordinate regulation with relevant polities, and c) create standards for the underlying technical specifications. The result of this process would be a set of ISO-like standards for interoperability, as well as mechanisms for self-policing (i.e. via trust metrics, or via cooperation with law enforcement).

The establishment of such a foundation will also be critical for the following reason: the hobbyist BitCoin speculator of today may be comfortable dealing with an anarchist with a nom-de-plume. Large institutional investors (and the US Congress) will not. A democratically elected foundation board, that includes people in suits (as well as bearded techies), will be needed in order to communicate with such parties.

The amount of press that this topic is currently getting highlights the fact that this is potentially the “ground floor” of a “once in a century” opportunity to build an effective replacement for existing markets. Whatever is done now will be with us for a very long time, and we need to make sure we do things properly.

6. Creation of equities – IPOs, standard contracts etc

There’s been a number of articles (note to self – I need to find them and provide links) about how equities in a digital wallet would be encoded. Generally speaking, we’re talking about some form of public key encryption that would be signed by the party that created it in the first place. The process of creating signed equity certificates would be similar to the “stock printing” process in “real world” markets, although it would likely be done directly by whomever issues the equity. There will need to be a well defined standard for how this will operate.

Standards for contracts will need to be established, and that process will also need to be determined. Currently, standards are set by individual exchanges (i.e. CBOT has a standard coffee contract that all traders on that exchange understand). Without standard contracts, each trade becomes a lengthy negotiation process (i.e. how many coffee beans are we trading, what is their quality, and where will delivery take place?).

The process for moving existing “real world” equities into a peer-to-peer market is going to be tricky, but necessary for its ultimate success. At some point, the involvement of existing organizations such as the OCC will be required.

7. The open source, peer-to-peer market

As I’ve stated above, virtual, decentralized markets are coming whether we like it or not, and there needs to be effort to do things right, up front, in order to avoid serious issues later on.

Ideally, we are talking about a self-regulating market, based on well defined, transparent, open source standards, with as few centralized “choke points” as possible. The market would consist of a large number of traders with digital wallets that store their equity positions, and a peer-to-peer mechanism for them to trade with each other. Escrow “brokers” and trust mechanisms, in addition to standard APIs and contracts will be needed in order for this market to work smoothly.

There are roles for many of the same players as in existing “real world” markets, and regulation and transparency will be required in order to allow them to do so. A guiding not-for-profit foundation, with a democratically elected board will be helpful in negotiating with existing governments and regulatory bodies. The participation of existing market players will be needed in order for this virtual market to operate – if we try to exclude them, we will only wind up creating similar (but less experienced and less transparent) roles on our own (this is already happening!); we might as well try to include them in the process deliberately.