Can Lonely Traders Make a Trade on the Blockchain?

I have been reviewing a number of blockchain initiatives, lately.  As an blockchain advocate with a history of working in the online brokerage business, I searched for trading exchange apps written as smart contracts.  If exchanges are completely decentralized on a blockchain, the theory goes, they could offer near-real-time, peer-to-peer clearing and settlement with no single point of failure.  Cool. 

I found an application called Etherex that has a full-featured trading ticket for placing limit orders on cryptocurrency trades.  The user interface is similar to stock trading sites I work with every day.  It has a two-part trade ticket – one side for buys, the other side for sells.   

I recognized the exchange model.  It’s a Continuous Double Auction (“CDA”).  Essentially, a CDA organizes a book of orders – all limit orders with prices away from the market.  Orders can be cancelled, and replaced, as traders edge toward eventual price agreement.  When there is price agreement, a trade is executed.  All this happens rather quickly when there are many traders in the market. 

But there is one little wrinkle.  What happens if there was no liquidity in the exchange?  

Unfortunately, low liquidity is a natural by-product of new technology.  Early adopters are a small group.  And because the exchange is built on a blockchain, the group could be very small, indeed -- as small as one or two traders. 

This chart shows the potential for failure if the wrong model is applied to a one-to-one trading situation. 

Since inventors are typically ahead of the curve, it is likely that blockchain exchanges will not succeed, initially, due to lack of liquidity.  That’s another way of saying: “Nobody will come”.  (Cue video of tumbleweed rolling down a deserted main street.) 

There is a possible solution.  If an exchange model can cover all the squares in the matrix, then there is a glimmer of hope.  

As developers, we should make many-to-many exchange capabilities a lower priority.  Instead, we should concentrate on creating a process of negotiation between a single buyer and a single seller.  That’s the logical starting point.  Until we solve that problem, blockchain exchanges will be fighting an uphill battle.