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Rethinking the Order Book: The March Towards Automated Markets

Traders Magazine Online News, September 5, 2018

Eyal Hertzog

If history is any measure, the adoption of new network models often lags behind advancements in computer technology. In the 90s, as it became clear the Internet could change the communications landscape, information providers took what was at the time a logical next step: They transferred their repositories online. Yellow Pages became and Encyclopedia Britannica became Britannica Online. Few could predict that crowdsourcing would eventually deliver far superior services in the form of Yelp or Wikipedia.

A similar pattern has emerged in modern-day asset exchange. Even as the digitization of trading has evolved and blockchain changes the financial landscape, existing market models have been unimaginatively carried over to electronic asset exchanges and now crypto markets. As a result, technology gaps between traders remain economically significant while the current market design perpetuates (and in some cases exacerbates) problematic features of the former system.

Blockchain and smart contract technologies enable new models that demand a rethinking of existing market mechanics?—?specifically the order book,which plays a key role in today’s digital asset exchange infrastructure. Modern-day order books are based on order-matching (between buyers and sellers) and mutable offers not visible to all traders. This paradigm makes order books dependent on for-profit matchmakers and susceptible to manipulation. The Bancor Protocol proposes automated order books, which allow underlying assets or tokens to be programmatically exchangeable without the need for both a buyer and seller, based on predetermined order-flows and transparent immutable orders. Automated order books dramatically lower the cost of creating liquidity and level the playing field for market participants by reducing both the risk of manipulation and the profitability of market-making.

The Magically Disappearing Order Book

The market for a single asset (digital or otherwise) is thought to be most efficient if all orders come through a single point, also known as the “order book”. An order book is an aggregation of buy and sell orders, showing the number of assets being sought or offered at each price level. It is intended to provide traders with better market information, but as we’ll see, order books can actually distort market information.

Order books are often visualized as two-sided graphs featuring buy and sell curves sloping upwards at varying rates in opposing directions. The lower the price, the more buyers are available to buy. The higher the price, the more sellers are available to sell. In between each curve is the bid-ask spread. Typically the lower the trading volume of an asset, the wider the spread because there is greater risk of illiquidity assumed by a market maker. 

An order book is an aggregation of buy and sell orders, providing signals about the price direction of an asset in the short term. The problem is these signals are just clues which can change at any moment.

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