Chief Strategic Officer of coinshares: building market microstructure for NFT

Published on 1 Months ago   255 views   0 Comments  

Note: the original author is the chief strategy officer of coinshares Meltem DemirorsYes, this article is compiled by the way of defi.

I've beenexploreThe evolving market microstructure around NFT. Recent about Sudoswap The discussion of the advantages of such platforms highlights some inherent tensions between the current NFT audience and future asset classes. A wave of large-scale platforms is coming, which will bring more powerful trader oriented market structure to NFT and other mysterious assets. As a result of the new model of technological innovation and financialization, the evolution of NFT market structure will provide a beneficial understanding of all market trends over time.

In this article, I will emphasize why there are inefficient markets, why market microstructure is important, and why NFT is not immune from arbitrage. Inefficient markets are always arbitraged by smart traders who see profit opportunities. In many markets, this may have existed for decades or even centuries. The inherent digital nature of NFT boosts this process and accelerates this timeline, as we saw in bitcoin and later tokens. I will share some brief thoughts on the future of culture as capital and cultural arbitrage from a market perspective, and how effective markets can help eliminate the widespread fraud in emerging asset classes.

Inefficient market 101

Inefficient market is the result of asymmetric information, high transaction costs, psychology and human emotions, and various types of market manipulation (including collusion and insider trading), to name a few.

Many "unique" assets, such as NFT, but also include real estate, collectibles, famous wines, artworks, and other assets affected by highly inefficient markets. However, technology can release new efficiencies. With the emergence of new platforms such as zillow, open door and compass, real estate has begun to become more efficient. These platforms can display unified real estate information on a large scale - minimize information asymmetry, simplify transaction execution - minimize transaction costs, and better workflow to manage these assets on a large scale. This has led to more companies trading in the real estate sector. In the past, real estate investors were highly specialized, and they had their own internal systems and processes, which dominated the asset class. However, the availability of more common tools and market infrastructure enabled more ordinary investors to establish real estate investment strategies.

To some extent, because our understanding of NFT as an asset is largely limited to the subjective world of "art", the NFT market is also inefficient. However, the biggest reason for the low efficiency of NFT market is the lack of market microstructure that can improve transaction efficiency.

What is the market microstructure?

It sounds fancy, but the market microstructure is only the basic details of how an exchange operates in a particular market. The process, technology and platform used in each stage of the exchange will affect the order depth, transaction cost, clearing volume, trading behavior and other important market indicators. The study of market microstructure is to understand how these trading mechanisms affect the formation of prices.

Today, due to the lack of a formal and unified NFT market microstructure, NFT has become a challenging asset class for market participants in large-scale transactions. However, the tool ecosystem can make NFTs available for quantifying trading strategies, such as momentum, arbitrage and volatility. It eliminates the need to select individual NFTs and makes it possible to program large and small transactions without having to look at NFTs or "evaluate" them. This is a huge potential unlocking of NFT trading volume and liquidity.

In order to decompose the market microstructure, it is helpful to understand the life cycle of transactions at a high level. The following is a brief description of the trading life cycle and some challenges of the current NFT Market:

Transaction life cycle:

  • Price discovery: interaction between buyers and sellers in the market to determine the price
  • Execution: agreement to purchase and sell in recorded and enforceable transactions
  • Clearing: record transactions, update accounts, calculate margin, and manage margin
  • Settlement: the actual exchange. When the assets change hands between the buyer and the seller, the transaction ends
  • Reconciliation: Post transaction activities to ensure that the transaction records are consistent with the records on the company's account books

Current NFT market challenges:

  • There are a wide range of buying and selling quotations on multiple platforms, which is difficult to summarize
  • Pricing is highly subjective and evaluation is not scalable
  • Multiple fields all different execution methods
  • Due to the need for collateral for bidding, capital efficiency is low, and there is uncertainty due to fraud
  • There is no central clearing center to handle net margin positions
  • Currently, it is managed by the trading party in its own system or by the trading place itself
  • The settlement on the chain is final
  • It is difficult to integrate into OMS, rely on aggregator infrastructure, or if it is an OTC transaction, there is a risk of DVP
  • It is an internal affair of the company's back office
  • Minimal software automation because there is no standard transaction booking format

In order to make the NFT market grow and expand together with asset classes, more protocols and platforms are needed to enable each stage of the trading life cycle to operate more effectively. Ideally, these modular components should be combined to form an automated and scalable work process, so that all types of market participants can deploy various trading and investment strategies, Whether it is a collector who chooses to add the Holy Grail fragments to the long-term collection, or an arbitrager who trades tens of millions of low-cost NFTs in a short term to generate profits.

Today's NFT ecosystem caters to the needs of collectors and amateurs. Tomorrow's NFT ecosystem will serve more utilitarian and speculative traders through a set of complex market microstructure protocols and platforms. This does not mean that collectors or individuals will no longer be market participants -- it just means that the way they interact with the market will change, and with the change of price discovery, the advantageous places they find will change. This may lead to considerable wealth transfer, which will benefit early market participants and collectors, and multiply the size of the NFT market. This process is called financialization and is part of the evolution of each market and asset class.

NFT is not immune from arbitrage

Naturally, the discussion about the financialization of the NFT market makes some people uneasy, especially those who currently benefit from the inefficiency of the above market. One of the core propositions is that the NFT market can never be traded through quantification and algorithms because of some sacred wisdom that only outstanding thinkers such as "poopy69 nftfan" or "jpegcollector420" can intuitively perceive. I think most NFT market participants today are bad traders. They are profit oriented, but they are inefficient and their earnings are sometimes good or bad.

Arbitrage is a natural part of all markets. When traders see the inefficiency of the market, they will design a trading strategy to profit from it and execute it again and again until this arbitrage opportunity is exhausted. Early merchants took great physical and financial risks to take advantage of geographical arbitrage. They drove camel caravans loaded with spices along the Silk Road, creating wealth for generations along the way. In the year 2022 of crypto world, those smart merchants with cartoon PFP will establish the strategy of using NFT arbitrage, smash the button, throw JPEG at the speed of light, and accumulate wealth for generations along the way.

The difference between erc-20 tokens and erc-721 tokens is mainly to clarify the functional economic use, or "monetization", of each asset. To some extent, it may also determine the market microstructure of each asset, although over time, I expect most of it will converge, because this convergence will bring more liquidity. We can see that with the passage of uniswapAcquisitionΒ Genie integrates NFT, and this trend is accelerating.

Erc-20 tokens are useful as "money" because they can be used as an account unit and a medium of exchange, and perhaps also as a store of value. This makes it easier for us to understand and predict the evolution of the market microstructure of these assets, because our current behavior towards money and monetary assets has been based on our belief in market efficiency as a positive attribute. When it comes to these assets, we don't question the arc of progress, because they are in line with our mental model from childhood.

Due to the unique nature of each asset, erc-721 or non homogeneous tokens cannot be used as "money", but this does not mean that they are not affected by the same evolutionary arc from the market perspective to some extent. Compared with monetary assets, the cultural narrative around NFT is an effective mechanism to promote more audiences to participate in the market, because culture is more interesting and generally easier to understand than finance (although I think finance is super interesting, I write this article because I want to make finance easier to understand).

However, media cannot change information -- like all chain markets, NFT is very suitable for efficiency driven trading strategies. At this point, there may be more subtle and technical dialogue, but I just want to arbitrage the culture.

Imagine an efficient NFT Market

Put all these together, what will an efficient NFT market look like?

Price discovery

How do you collect data about NFT? How do you know the price of an NFT? How do you find the best price for your transaction? How can you view an integrated "book" in a simple interface and display all lists of all collections?

Today, the most commonly used discovery platform is opensea. However, the data provided by opensea interface is quite small. Apart from the data that can be collected on the chain, it provides little insight. Opensea also restricts you to view the list on their platform. What you see does not always represent the full range of the order book.

Genie It is a market aggregator that pulls pricing from many different markets, including opensea, looksrare, etc. it not only integrates price data from the market, but also adds UpshotΒ *The data itself is integrated into the machine learning algorithm from a wide range of qualitative and quantitative data and can be consumed through the API. In addition, there are RaritySniper For those who still attach importance to rare data. Please note that I personally agree with two of my favorite NFT thinkersaxiomΒ --If it's not the Holy Grail, it's the floor.

However, all data services, aggregators and market platforms today focus only on summarizing the listing or sales price. We have not yet seen the development of structured data feeds or aggregators that show the depth of the market, including bids or purchase prices, and the settlement prices of these bids. Therefore, it is difficult to determine the depth of the market. As shown in the figure below, the market liquidity is determined by the depth of the order book, and the price is determined by the range of order clearing. If we do not understand the price difference summary of various sites and OTC transactions, the price discovery will be incomplete.

  • Liquidity involves a trade-off between the price at which assets are sold and the speed at which they are sold.
  • Liquid assets can be sold quickly at any time in the market time with minimal value loss.
  • In traditional markets, speculators and market makers provide liquidity
  • More liquidity leads to smaller bid ask spreads, while lower liquidity leads to larger spreads

At present, there are many price discovery platforms being established, which are useful to traders in varying degrees. Many platforms are more for collectors, focusing on features, rarity and other data points, without any operational insights. The emergence of a price discovery platform focusing on market insight and asset specific data is the place where miracles occur. Upshot is currently in the leading position in implementing arbitrage trading strategies, although we have not seen a fund or product integrate these data to establish a pure arbitrage driven strategy. But maybe someone will build such a product soon

I also expect the OTC market to become more efficient. Like ParadigmΒ *Like the large-scale request for quote for bitcoin and other cryptocurrency options, we need a batch inquiry platform for over-the-counter NFT transactions. I hope to be able to bid hundreds of NFTs at a time by clicking a button and using specific search parameters, instead of bidding hundreds of times on different platforms. Perhaps the on chain message solution will help make it easier. Smart snipers are already using wallet level messages to send quotations, obtain the best price, and avoid market costs (see blockscan).

Transaction execution

Once I have identified the asset I want to trade and have confidence in the price discovery, I want to execute the transaction. Many markets and aggregators today bundle transaction execution, price discovery and settlement into one interface. Some NFT collections are even establishing their own protocols or interfaces for transaction execution. For example, larvalabs directly embeds its cryptopunks market on its website, while etherrocks can only trade on etherrock's website, because these early NFTs appeared when there was no trading market. Today, efficiency requires aggregation. Sudoswap is such a building block. By supporting the development of liquidity pools, it allows market making in the whole set by responding to the adhesive curve of market dynamics, thus making large-scale aggregation and execution easier.

In the above example, people can sell or buy dickbuttons in eth according to the exponential bonding curve. Sudoswap also allows you to bid on all the capital pools in a collection, which means you can bid on multiple liquidity dickbuttons by clicking one button.

Uniswap also adds NFT to its protocol, which will be an exciting step in the integration of token and NFT markets and enable more applications to take advantage of uniswap's liquidity. The key is to make execution simple, procedural and extensible, regardless of the order type.

At present, the best solution for large-scale purchase is: (a) to use opensea, genie or gem that will soon become uniswap to sweep the listing hall, or (b) to find large customers, negotiate batch bids, and conduct DVP (delivery and payment) settlement. However, this has unique risks, which will be discussed in the settlement section.

Today, there are few over-the-counter brokers trading NFT, and most bulk sales are often conducted among specific collectors. Large scale procurement is challenging, but I expect that we will see more professional over-the-counter brokers and market makers appear. They conduct large-scale transactions in the off chain and on chain NFT markets, specifically clearing or accumulating considerable positions without affecting the market price. As in the past, the main challenges in the execution of OTC transactions are the opacity of such transactions and how to integrate these market data into the pricing model, especially when the transactions are settled outside the chain.

Margin and clearing

One of the biggest limitations of NFT liquidity is the clearing and settlement process, and the trading floor requires that collateral be submitted when you bid. Suppose I want to bid on 100 cryptodickbuttons in a batch bid. Opensea will ask me to package eth into wth, and then release 100 bids to lock my wth for several days. Although I can provide the minimum number of weth to minimize capital drag, it also means that I may have multiple bids that cannot be clearly matched. This is very low capital efficiency and may lead to sub optimal execution. In order to make NFT more liquid, we need to be able to bid on any other asset and reduce collateral requirements.

Maybe it can be integrated like CredoraΒ *In this way, the chain clearing house of credit management can be realized to help promote better capital efficiency. Perhaps we will see the emergence of a major broker to provide short-term credit for such bidding. However, from the perspective of structure, this problem may be one of the biggest challenges to be solved. Especially for the chain transactions, basically all NFT transactions today are on the chain. If NFT clearing is transformed into a center radiation model with daily settlement instead of instant settlement, the process will be easier, but also more centralized. Alas, efficiency and decentralization are always difficult to achieve.

In terms of margin, such as NFTFi Such a platform enables NFT holders to use their existing NFT as collateral to obtain more liquidity for trading. Upcoming AstariaΒ *It promises to provide immediate liquidity for NFT, and classifies the borrower into a fund pool to pay income, rather than dividing it by the payee. OTC companies and major brokers also accept NFT as loan collateral. In particular, genesis used the funds raised by NFT to lend to NFT fund Meta4 in January 2022 US $6 millionAnd then the fund is used to buy more NFTs. This is called adding leverage, and leverage is the lifeblood of modern financial markets.

Today, obtaining leverage is expensive and often occurs outside the existing order process. You must enter a separate platform, transfer your NFT to a escrow account, and carefully manage the margin. Integrating margin directly into the trading workflow can help traders obtain leverage more stably and on a larger scale. However, lenders need better price setters, which goes back to step 1, that is, price discovery is not only important to traders.

The big opportunity for NFT is to improve capital efficiency. Systematic trading requires capital efficiency, because the profit of arbitrage tends to decrease over time, and your profit must exceed your capital cost. For example, if you can continue to use 10-15% of short-term price arbitrage, your capital borrowing cost must be less than 10-15%, preferably a considerable range, so that you can record the profits and make the work worthwhile. In addition, an important measure of portfolio managers is ROIC or & quot; Return on investment capital;. If I have 100 eth, but I can only trade twice without leverage to obtain 6% ARB, my ROIC will be much lower than I have 100 eth, but I can use 4-5 times leverage to amplify my return per dollar, because the 6% ARB is now amplified several times.

Settlement and post transaction reconciliation

The last step in the transaction cycle is to settle the transaction, which means asset exchange and then ensure that the settlement occurs as agreed. This is called reconciliation. The biggest advantage of the chain market is real-time settlement. NFT is an important proof of collectibles, artworks and other unique markets. The settlement of these markets is non-standard, high cost or requires special drag pipes. Today's NFT settlement makes use of smart contracts to realize atomic exchange without requiring a trusted third party to mediate delivery and payment (DVP), which has great advantages over other types of assets. The origin of NFT is easy to track, and the authenticity can be verified on the chain.

Given the informal and non-standard nature of the previous steps and the lack of standardized data formats and APIs, the least structured part of the NFT transaction lifecycle is reconciliation. Collecting data and integrating it into risk management or back office systems is usually a manual and labor-intensive process, which requires data collection, cleaning and standardization. Perhaps tools such as crypto * that implement more extensive background functions for encrypted assets will also develop NFT report modules, but then real-time monitoring of positions and allocation of value will require better pricing data -- so we return to step 1, price discovery! To track public bids and quotations and any margin requirements, all positions need to be summarized into a company level view. If the risk parameters or thresholds are exceeded, real-time data feedback can also be implemented in real-time.

Over time, I am optimistic that more standardized data APIs will make it easier to manage reconciliation without requiring so much manual work. In addition, it will also make it easier to apply tax and accounting coverage and make real-time profit and loss tracking possible. For example, the widely used fix (financial information exchange) standard is a supplier neutral electronic communication protocol developed and served by the trading community in 1992. Fix has become the information transmission standard for order workflow communication and regulatory reporting. Fix API ensures that your data is compatible with every transaction, accounting and risk management system established for the modern capital market. The inherent structure of blockchain as a public data layer makes it easier to extract data. However, before defining a more formal workflow for NFT transactions, it will be difficult to determine how to best summarize and coordinate data among protocols, platforms and applications.

Although reconciliation looks like a business that is not sexy at all, its stickiness is incredible because all companies need it and build their processes around it, and it can also become a great recurring revenue / money tree business. Keke


In the long run, traders may not only trade related NFT, but a new type of synthetic derivatives or forecast market will appear in this field, enabling traders to make directional bets instead of trading related assets. In the short term, the opportunities are quite obvious.

All parts are not fully in place, but anyone can see what is coming. The microstructure of NFT market is gradually becoming more clear and orderly, and will create opportunities for new market participants, operators and investors with infrastructure. It remains to be seen which parts of the transaction life cycle will be established and commercialized as independent platforms or protocols, and whether there are players trying to establish or acquire the parts needed to establish a vertically integrated NFT transaction workflow.

But, meltem, this is harmful to culture!

Finally, many people say that it is a bad thing for arbitrage driven traders to enter the NFT field. The behavior of injecting cultural capital into financial capital has been a major trend in the past 20 years. Although it is indirectly exercised through the rise of social media and influencers, this trend will continue to be ready and become more visible with the erosion of cryptocurrency on culture.

The era of institutions has passed, the era of influencers will soon pass, and the era of degens will follow. The Kardashian family is richer than most hedge fund managers. According to the deposit situation, coinbase ranks among the top ten banks in the United States. Anonymous traders have built profits and losses comparable to those of the PM of the most famous traditional trading company on Wall Street. Soon, anonymous cartoon avatars will dominate the NFT market, turning over the original and exquisite JPEG.

Whether you are selling several eth or billions of dollars, the chain market has begun to achieve a level playing field by enabling anyone to become a market maker or a liquidity provider. If you are interested in this, you canhereFind a full 20 minutes on how cryptocurrencies make us hedge fund managers.

With the reduction of information asymmetry and the improvement of market structure, all inefficient markets will become more efficient. The argument that cultural capital is not affected by this model to some extent is at best intentional ignorance. The mechanism has determined how you consume culture. Don't delude yourself into thinking you have good taste. Just look at NFT. First, how did you find NFT? How many times have you bought something because an NFT influencer promoted it on your twitter timeline? Applying the cultural purity test to your participation in the market is a good way to embrace poverty and sadness.

Consensus around culture creates value. Due to the existence of upshot, context *, flip and other tools, the consensus emerging in the NFT market is a mode that can be discovered and emerged by using quantitative and qualitative information. Today, cultural capital has been arbitraged, but only limited to a small group of internal players. Why not democratize this process by providing transparency and tools to benefit more market participants?

Some people may say that this is Utopian, but I disagree. The market is becoming efficient, and technology is only pressuring it in new ways. It can be said that the real problem is that effective markets do not benefit insiders - there are a lot of fraud in inefficient and opaque markets such as wine, art and collectibles. We have also seen this in the capital market -- every wave of technological innovation will bring fraudsters who sell rights and internal information -- we have seen this in tokens, marijuana stocks, and now NFT. Fraud and financial foam will always exist, which is caused by human nature and an inevitable part of the market. No technology can change this (at present). Therefore, when people protest against the pace of progress, it is often because they are afraid of the structural power transfer caused by such changes.

You can resist the arc of progress, or you can embrace it. History does not build statues for critics. Investing in progress is for profit. Please make your choice accordingly.

Finally, if you are building a market microstructure for esoteric assets, I would like to talk with you. You can easily find me online.

Disclosure: I am an investor investing in paradise and credora through coinshares ventures. I invested in upshot, astaria and context through my personal holding company. I have a lot of cryptodickbutts.

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