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Ava Labs x CBER Ep 6: Regulation of Decentralized Exchanges
95 Plays1 month ago
Professor Campbell Harvey (Duke University) and Professor Joel Hasbrouck (NYU Stern) explain the novel risks for traders who trade at Decentralized Exchanges (DEXs) and why standard regulatory approaches are not well-suited for addressing those risks. The podcast then discusses the feasible paths for regulation weighing the relative advantages and disadvantages. An important point is that regulators are not necessarily properly aware of the challenges of regulation in the blockchain context and, as a consequence, some regulatory actions being taken might be counter-productive.
Paper: The Evolution of Decentralized Exchange: Risks, Benefits, and Oversight
Recommended
Transcript
Introduction to the Podcast Series
00:00:06
Speaker
Hello and welcome to Crafting the Crypto Economy. I am Silvia Sanchez, Project Manager at OWL Explains by Avallabs, and today we bring you a transformative podcast series in partnership with the Crypto and Blockchain Economic Research Forum. This series features leading faculty from renowned global universities exploring various elements in the blockchain ecosystem. These episodes are a bit longer than our usual hootenannies, since we will be getting very deep.
00:00:33
Speaker
And also, each episode will have its accompanying paper posted on our website for further reading.
Meet the Experts: Joel Hasbroke and Cam Harvey
00:00:38
Speaker
And with that, I will hand it over to our moderators Fahad Saleh and Andreas Park. All right. Welcome, everybody, to another edition of the CBAR Owl Explains podcast series, um where we are discussing topics relating to crafting the crypto economy. um I'm your host Andreas Park from the University of Toronto. um My co-host Farhad Saleh is also in the room and we're very excited to be starting the second season of our podcast series now. um In the last season we had five five editions and we finished with a podcast with Lewis Cohen where we discussed the regulation of crypto securities. That was very much focused on the regulation of the assets themselves.
00:01:25
Speaker
ah In today's edition we we we will be discussing decentralized exchanges and in particular we are asking questions such as what kind of topics and risks emerge, what oversight may we see at some point in the future and how different developers in different parts of the ecosystem will have to address these.
00:01:45
Speaker
Now Fahad and I are really excited because we have two of the most esteemed scholar scholars and in the world of business school finance in the room. ah Joel Hasbroke from NYU and Kam Harvey from fukqua from the Fuqua School of Business at Duke University.
00:02:01
Speaker
I'm just going to give you a little bit of a background of ah why ah Fahad and I are so excited about the two of them. So I'll start with Joel. Joel has been a key figure in a field called mac microstructure. This is the part of economics where we ask questions such as how do trading institutions affect market outcomes.
00:02:18
Speaker
um He has been instrumental and developed a set of tools that all of us in the field use on the estimation of information content of prices and auto flow. He has been a founding member of the MBR microstructure group. He has a conference that he organizes every single year. And he's just generally somebody who we all look up to in the field and has helped many junior scholars, myself included it in getting started in this field.
00:02:45
Speaker
um He's also deeply involved, which is somewhat part of this field in particular with the financial industry, with brokers, exchanges, and also the regulators. So he has very deep insights of how they think, how they operate, and you know what kind of constraints people face in the business. um He's recently started working on decentralized finance, in particular was is interested in index trading, and has written a couple of paper on these, and we'll start talking about some of his work there.
00:03:14
Speaker
Now, let me talk about Cam Harvey. ah Cam has a a very long and esteemed research career. And he has made contributions in at least three ah fields of three areas of finance. So the first one was that and it has nothing to do with blockchain, which is interesting for the audience generally. It's the first to assert that an inverted yield curve where short-term rates are higher than long-term rates would predict a future recession. um And that really matters because these inverted yield curves have correctly predicted ah the last three recessions in 1989, then 2000, 2006. So each of these basically followed the mechanism that he asserted. um He has also written a large number of influential papers in corporate finance. So for instance, he has worked on saying that 80% of CFOs admit that they would be willing to destroy value in a firm just to meet quarterly earnings targets.
00:04:09
Speaker
um has made many important methodological advances in differentiating luck versus skill in management and he has shown that opening financial markets to foreign investors lowers the cost of financing and increases investment in GDP for emerging markets.
00:04:26
Speaker
Finally, he gave all of us a big fright in the empirical part of finance, where he showed that about half of empirical ah research in finance is most likely wrong because of p-hacking, ah which just means basically that you try to search for results just to find significant effects.
00:04:43
Speaker
um That, of course, got him very popular in there in our own business. um For this podcast, it's important to know that Cam was, I believe, the first economist who actually worked on blockchain and and thought about blockchain and how it affects markets. He wrote a seminar book on DeFi, and he made many research contributions to the regulatory but debate. not all of you know Just be clear, you know we are academics, and Cam has sees it with ah you know sees both the book Good and the Bad. He has a recent paper in management science on crypto.
Decentralized Exchanges Explained
00:05:14
Speaker
I should also point out that for those of you who have seen maybe the clip, they're both of these both of both Joel and Cam have written major textbooks in the in the field. we see you know Behind me, for those of you who can see the video, I put up both Joel's books and Cam's book on DeFi and empirical micro microsearch. Okay, this was a very, very long introduction, and I apologize for it. um Now, this particular podcast is about decentralized trading, and so maybe we should just jump right into the topic. um and I'm going to start with you, Cam. What is it, Dex? So, to understand decentralized exchange, it's, I think, useful to think about the current model of centralized exchange. So, think about opening up like an account with Robinhood,
00:06:01
Speaker
you have to provide a lot of information. You need to get funds to Robinhood. So you need to do like a bank transfer that could take two to five days. You've got an account, then you do some trading, so put your order in, and Robinhood actually doesn't do the execution. They sell the order to a company like Citadel Securities. They execute the order, and then the the stock actually sits at Robinhood in Robinhood's name. ah And ah you could repatriate that stock, ah but that takes time. So to settle a transaction ah is now like 24 hours.
00:06:48
Speaker
and And let me contrast that with this new space of ah decentralized exchange. So decentralized exchange is based upon a smart contract in the Ethereum of blockchain. It's an algorithm. So there's no setting up an account. ah You actually have a wallet and ah you connect your wallet.
00:07:11
Speaker
And the decentralized exchange is usually a pair of assets, and you see a price, and that price depends upon how much you're buying.
00:07:24
Speaker
which kind of makes sense. So you buy more, ah the price is higher. And this decentralized exchange is funded by liquidity providers. Those that put liquidity into this pool, ah they do it because they get a fee ah for actual trading. And ah you have liquidity that's relatively constant 24-7.
00:07:49
Speaker
So this decentralized exchange is available at any ah time. And it is very transparent. So you can see i all of the details. ah You can see what's there. And again, you connect wallet.
00:08:08
Speaker
and you send what you own to that exchange, it sends back ah what you're buying. There's no ah middle person holding your keys or your tokens. ah This has to do with you. So this is ah an innovation that's very interesting. um Indeed, this algorithm doesn't care if you're a buyer or a seller.
00:08:37
Speaker
So I do think that this is something that's highly disruptive. ah It's a fresh idea. And and indeed, um Joel and Fahad and I have been working ah diligently on a paper trying to understand both the differences between centralized exchange and decentralized exchange, some of the risks, the opportunities that are presented, and ah reasonable strategies in terms of oversight.
00:09:08
Speaker
so if if you don't mind so Okay, so it's a smart contract that runs on the blockchain and that does the processing basically without, you know, anybody who who can connect to the blockchain can also use these exchanges. and I'm not sure if any of you may want to want to jump in on this, but um this all sounds still a little bit magical, right?
Regulatory Challenges in Decentralized Finance
00:09:29
Speaker
Because there's some some type of some type of exchange, some type of program that just pops up. is there Could you maybe make this a little more um Let's say tangible of how would how would actually somebody ah you know who has an idea for an exchange, what do they have to do for this to to go live? And then how do people actually trade and use it? What's the what's the process there that I have? so Because normally you know with ah with a market, if you go to Robinhood, there's a firm that uses established mechanisms that have been around for several hundred years. There's marketplaces we can think of. The New York Stock Exchange is a building and all that.
00:10:07
Speaker
But what what is happening here? yeah Let me just jump in quickly, and I'm sure Joel and Fahad will want to add to this. So there's like two different sides to this. So number one, anybody can set up a decentralized exchange.
00:10:22
Speaker
So it it can just be deployed. So you can set up a liquidity pool, let's say, ah US dollar coin, USDC, um and ETH. That might be a pool. And anybody can set that up. And it doesn't have to be one. There could be many of them. So thousands of these decks. So they can be deployed from the US. They can be deployed from any country.
00:10:44
Speaker
um And then the other side are the actual users. So you can actually go and choose one. And the way that this works on the Ethereum blockchain is that everything is interoperable. So in a single transaction, it's possible to buy something on one DEX and sell it on another.
00:11:03
Speaker
So it's quite ah straightforward to do. So an example might be that I've got a wallet and I've got some a US dollar coins, so a stable coin, um and I want to buy some ETH. So I go to a DEX and I send the DEX some USDC and there is an exchange that's quoted.
00:11:26
Speaker
and And then essentially, once this gets put on ah the Ethereum blockchain, the transfer, there will be a transfer ah to me in terms of ETH. So what I hear you saying, Candor, is that ah decentralized exchanges are much easier to access, for one.
00:11:51
Speaker
than traditional financial markets. And this, I think, is a point that people in the the crypto community are quite happy about, and and they speak of it as kind of one of the big benefits of this space, increased financial inclusion, increased access, etc. If I can put my co-host hat on for a moment here and maybe turn the question here to Joel. um Could you say a little bit about how regulators might think about the same idea of the ease of access. And also maybe if you could relate it a little bit to the regulation that already exists around centralized exchanges, which would maybe then flesh out a little bit the differences um between centralized exchanges and decentralized exchanges in terms of user interactions at this point in time.
00:12:40
Speaker
Certainly, ah I'll do my best. First, ah all markets have this tension between centralized and decentralized features. And and to get to the kind of world that Cam has just described,
00:12:59
Speaker
d We might start from a traditional exchange, a floor-based exchange, well, like the New York Stock Exchange or one of the Chicago Futures pits. They're centralized physically. Everybody who wants to trade goes to a trading floor or sends an order to their broker who's on the trading floor. It's very centralized. And the advantages of centralization have always been that um ah everybody, you get all the buyers together, all the sellers together, and in that way, you maximize the competition on both sides.
00:13:45
Speaker
Now, the problem with this centralization is that it can very easily easily turn into a monopoly. And I don't want to debate whether the New York Stock Exchange or the futures pits were monopolies, but they certainly had a lot of market power. That was undone when markets started going electronic.
00:14:10
Speaker
Once they started becoming electronic, they no longer were tied to a physical floor, but there were still strong institutional ties.
00:14:23
Speaker
All right, my order to buy General Motors stock still went to the New York Stock Exchange, even though it didn't go to the actual trading floor. It went to a computer owned by the exchange, operating a few blocks away. Now, at that point, um exchanges became very automated.
00:14:47
Speaker
And they were defined not so much by their culture of their members, but by their detailed trading rules. And by the end of the 20th century, those rules had coalesced around a very common and popular form of market design called the central limit order book.
00:15:12
Speaker
And the central order limit order book is really defined by its software, not its physical address on Wall Street or LaSalle Street. So once you had the exchange being constituted in software,
00:15:31
Speaker
It could run just about anywhere. And in fact, to- today, there are many exchanges who run NASDAQ's stock software, for example. And I think this is being a first step to decentralization because now the market has become like an app and it can run anywhere. But in order for me to trade,
00:15:59
Speaker
I need not just a market, I need a counterparty, somebody to trade with, somebody to take the other side, somebody who's going to sell when I want to buy and vice versa. And that I think is one of the most interesting innovations of decentralized finance, the automated market maker.
00:16:25
Speaker
And this is the algorithm, or one of them, that Cam was talking about, and it provides security, transparency, and as Cam quite correctly pointed out, anyone can set one of these up, and they can run just about anywhere.
00:16:51
Speaker
So in in terms of the traditional exchanges, one of the things that we're excited about in this space is that it gives, opens up the possibility to all kinds of different market structures where the traditional exchanges are pretty much bound into this central limit order book model.
00:17:18
Speaker
It's not a bad model at all, but it has become sort of rigid. um The automatic market maker, think of this as another kind of app that any of us who wants to trade can tap into.
00:17:38
Speaker
and give us ah liquidity, ah give us the opportunity to trade on clear and transparent terms. That's a very useful service to be able to provide. Now, anyone can set one of these things up if we have a thousand of them.
00:18:05
Speaker
Is that a market that's easy to use? Well, at this point, we start thinking maybe a little bit of centralization might not be such a bad idea. And the regulators in particular, and I'm thinking about ah the the the Washington regulators,
00:18:28
Speaker
ah In the US, securities markets are also regulated by states. um But regulation is, for the most part, a centralized function. And that's where we're starting to see, I think, a lot of the tension between decentralized markets and centralized regulation.
00:18:53
Speaker
Let me stop there and and pick it and and open it up.
Complexities of Global Blockchain Regulation
00:18:57
Speaker
So if I could jump in there. So um what I'm hearing from you, there i mean there's obviously a lot of different changes that we can that we can see with the introduction of this, especially these automated marker makers. So just to summarize it, there's a difference in how they're operated.
00:19:13
Speaker
They're different as in how and who can access them and who can create them. And as you say, one of the most important things is probably the difference in in how the trading is is organized in terms of, I think you didn't use the term, but you know you use the term counterparty. you You can also think of the term as we like, I think the the common term that people like to use is liquidity, right? So, yes, the ability To convert an asset into cash or vice versa at any given point so this is um mean these's obviously very major changes and but before we jump into thinking about. um You know the the roles of regulators and how they think about it maybe it's it's worth thinking about.
00:19:53
Speaker
um I mean you can have market without regulators right so we have a lot of markets not financial markets per se but lots of them work without a direct involvement of a regulator and the reason why we do see regulators usually this is something that that prompts them to to appear so maybe we should just spend a few minutes about the history and maybe discussing some of the some of the reasons why we actually believe that ah trading in markets in some form needs to be regulated. I'm not sure, Kam, do you want to maybe start with this? or
00:20:24
Speaker
Yeah, like even before we go here, um I just want to emphasize that ah the difference between decentralized markets and decentralized, that ah we talk about counterparty. ah Well, it it is the liquidity pool.
00:20:41
Speaker
And that pool is just there. um and And that liquidity is relatively constant. So you've got a market. You've got prices 24-7. And importantly, um you're not allocating custody of your assets to anybody.
00:21:00
Speaker
so So you're always holding your assets. So there's no third party um that has control over your assets. And then I also want to emphasize the the settlement. So the settlement is ah is almost, and it's not exactly, and we'll maybe talk about this a little later, um it's almost instant. So the the execution and settlement very close to to one another. Whereas in traditional exchanges, this takes quite a while. And and as Joel said, the centralized exchanges have moved to you know somewhat ah towards a decentralization. But it is the case that if you're thinking of listing a stock, you're you're choosing between like NASDAQ and NYSE. Whereas in this technology,
00:21:55
Speaker
ah There's no choice. anybody but Anybody can set this up. so It doesn't have to be a company that's sponsoring a token. It could be anybody setting up an automated market maker decentralized exchange. so so This is ah a significant innovation.
00:22:14
Speaker
and a significant ah deviation from past practice. And what what is missing, ah and maybe it's not surprising that this is missing, is a sense of of oversight.
00:22:30
Speaker
ah So we've got very substantial oversight for centralized exchange. And then you have this technological disruption um with blockchain technology and Ethereum smart contracts where ah we don't really have a framework ah for that.
00:22:49
Speaker
and ah and And certainly in in our research paper, we detail that while there are many advantages to having a system that is decentralized, there are also some risks.
00:23:05
Speaker
So ah for example, um people could set up a decentralized exchange um for a token that they know is worthless and engage in some sort of pump and dump ah scheme. So there's many aspects of of this technology ah that ah provide downside risk also and and regulators need to weigh that trade-off so on one hand you've got all of these advantages transparency quick execution low trading fees very competitive on the other side ah there are some downsides and the regulators
00:23:52
Speaker
need to come up with some balance. And on top of that, this is really difficult just to think about regulation. So Joel mentioned LaSalle Street and Wall Street. Those are like physical locations.
00:24:08
Speaker
i These contracts reside on the Ethereum blockchain or a competitor ah blockchain, and and that's not in any country. So yes, there are nodes in the US, but it's all over the world. So it's so it's really hard to think about a national regulator ah dealing with the technology that's fundamentally global.
00:24:36
Speaker
So the regulator needs to have some sort of balanced approach because any draconian policies um are not going to be effective because the you know the sponsor will just move offshore. And no country wants to use lose their best innovations. so So it is very challenging to think about this with the decentralized technology that the global technology ah How do we think about regulation when i this is not just within ah the US? s So let me just jump in for one second because at the very beginning you said actually two things that I thought
00:25:19
Speaker
but quite important, which are also going at ah some of the things that are ah ah at the core of the problem. So you basically said, um so you never have to give up custody. I think this is really quite important because it points to a problem that we have in traditional markets because you have to give your assets essentially to a third party or you need to ask a third party to look after your assets because you know you may want to make sure nobody takes off with them whereas in the blockchain world you have control so that makes already it also shows us that there is something fundamentally different and that there are some problems that arise in the traditional world that may not arise in the blockchain world.
00:25:57
Speaker
and Then the second part that you mentioned was the settlement. right so um mean Just for the for the benefit of the audience, and and Joel, you can correct me on this, but I think there's something on the order of ah half a billion dollars each day that doesn't settle. right and that's ah i mean you know On the grand scheme of things in terms of how much value changes and that's not an awful lot, but it's still a lot of money. right It's not pocketing.
00:26:21
Speaker
Well, yes, i i think i i don't think it's yes in a they are called failed settlements. That doesn't mean that the money is lost.
00:26:33
Speaker
ah As a practical matter, that means that settlement is deferred. So yes, I promised to give you Apple stock today. I don't have it, but I will have it tomorrow. Let's work out a deal. So it's not that the system is, is I don't think of it as as leaking.
00:26:55
Speaker
ah more as just a little bit creaky and not going as fast as it could fair enough but you know i think there's an important nuance to this which is you have a regulator in there to make sure that these failures to settle are kept at a minimum right so the fact that they actually are being worked out is I mean, there's obviously multiple mechanisms behind it, but it it shows that there is a particular problem of some form that arises that makes sort of, as you say, it creates frictions and it creates creaks in in the financial system that that are not a positive, right? um Except if you go to, you know, 2008 when probably this, you know, the that settlement cycle and the and changes and and the delay for settlement may have been a positive to avert a bigger crisis. But so but what I was getting at was,
00:27:43
Speaker
and and to have If we want to have this debate about how to regulate, I think it's important to note that in the blockchain world, some problems don't arise that otherwise would arise. and so I think that's kind of what I was asking. Andreas, i I have to take issue with that. ah When we look at the conventional markets and we hear that ah settlement is one day,
00:28:08
Speaker
That is, it takes me a day to to get legal title to a share of Microsoft stock that I just purchased. And this can be done in a matter of seconds on the blockchain. It it it it seems like absolutely no contest. Of course, we'd prefer the quicker settlement.
00:28:29
Speaker
um I don't think it's that simple for a couple of reasons. One is, ah although the settlement delay is long in conventional markets, the amount of risk that is borne yeah over this long period is actually very small. When a trader executes a trade on a centralized exchange in equities in the US,
00:28:55
Speaker
That trade within microseconds is considered to be locked in. The identities of the buyer and seller, the quantity and the price are confirmed, and everything else that goes on over the next day is really details that just sort of sweep up some of the formalities of the transaction. ah Joel, Joel, come on. Joel, ah what about Robin Hood almost went under because of the two-day settlement? So this is not just about an individual train. Some of these institutions, these centralized institutions, Robin Hood, very healthy, very profitable, and was
00:29:40
Speaker
almost bankrupt because of this delay in settlement. And who knows what would have happened ah if it did go under. So this delayed, this friction, well, you might not feel it that much for an individual, a trader. It can aggregate and cause potentially systemic risk. It is a friction. and Absolutely. I think that's it's important.
00:30:08
Speaker
and not just ah Robin Hood in the meme stock era, but also most countries at various points, including the US, have had paperwork crises, settlement crises that can impose very real costs.
Blockchain's Impact on Trade Settlements
00:30:27
Speaker
I don't mean to imply that the settlement problem is trivial, nor do I believe that the settlement problem has been licked by blockchain methods.
00:30:39
Speaker
um the ah turning to settlement on a decentralized exchange, it operates on the cycle of ah black block authentication, 12 seconds. And that doesn't sound like a very long time, except that during that 12 seconds, the terms of my trade are not locked in.
00:31:06
Speaker
They are not locked in until that has been cleared on the blockchain. And 12 seconds, as any high frequency trader can tell you, is a very long time ah in a market where trades can be broken, recomposed, repriced,
00:31:27
Speaker
i This is one of the surprising things, at least surprising to me, about decentralized finance, um that if you actually do a trade, the confirmation, ah all of the things that can happen to that trade on their way to final settlement.
00:31:50
Speaker
So before we jump into that one, maybe we can um um I can press you, Joel, just for a second because you've been interacting with the SEC and the CFTC. Can you adjust as broadly as you can? What are what are the major topics that these regulators worry about in the traditional markets and that that kind of are the the focus of of regulatory action and and really would justify the existence in terms of regulating the trading itself.
00:32:23
Speaker
um maybe Maybe we stop with that. Joel, before you answer that, if i if I can interject and ask a question that I think is going to ah come earlier in the conversation, and and in in the sense it follows up a little bit on what ah Joel you were saying a moment ago, which I think is a curiosity that some people in the audience might have and that I certainly have. When you were talking about the T plus one, um what is it that happens in that one day, which used to be two days,
00:32:50
Speaker
that is so important that necessitates this amount of time. And maybe that'll also provide a little bit of transparency into what Cam was referencing of the potential of risk from that time. um Could you say a little bit just about what actually happens in that time? Well, ah ah first, it's it's changed over the years. But the clearing process, first, we have to confirm the terms of the trade. I'm the buyer, you're the seller.
00:33:20
Speaker
If you've ever run a pit market in a classroom, you will know that two people will do a trade and surprise. They think they're both buyers. So it's very important to get the identities of the buyer and seller confirmed that they agree on the price. They agree on the quantity and the error rate, of course, now with automation is much lower than it was ah in the era of the floor markets where these things were were just you know written down with pencil and paper. um But errors can still occur. And also we have to make arrangements for ah the transfer of the cash and the securities. And this is one of these things that I absolutely agree blockchain methods excel at.
00:34:15
Speaker
um they can if if an If a share of stock could be tokenized, it could be transferred ah very easily and um ah and and reasonably quickly. Also, remember, um money, cash, payment has to be transferred as well. So now we're dealing with the banking system.
00:34:45
Speaker
So um I actually think that at this point, with the Depository Trust Company ah handling most of that ah work with ah ah listed equities, um probably most of the frictions are arising from the payment system. um That is the transfer of cash rather than transfer of shares.
00:35:14
Speaker
um If I can follow up briefly, just if I understand it correctly, though, there is sort of an important technical distinction in that on the blockchain, essentially, you have these assets that are created and settled directly on the blockchain. And so you're sort of doing things within the same system. Whereas in the traditional financial system that we have, you essentially have assets on different systems and that's going to take some time to to reconcile. Is that fair? ah that's That's partially fair, but even I would say um um on a blockchain system, um it's it's not inconceivable that you would be doing in effect two different systems. For example, if you are doing a swap of one kind of asset for another,
00:36:04
Speaker
They're both on the same blockchain great, but if they're not, that has to be co coordinated so that they the transfers take place contemporaneously. not Not rocket science, but not completely trivial either, given the size of the transactions involved.
00:36:26
Speaker
but But it is striking, Joel. like You mentioned these four things, identity, the price, the quantity, ah checking for errors, and arrangements for transfer. And you just go through those four frictions in the decentralized space. And well, identity, there there's an address. So check that box. Price and quantity, it's it's an algorithm.
00:36:55
Speaker
um Checking for errors? Well, it's an algorithm. And ah the arrangements for transfer, well, ah that's what this technology does really well um in in terms of being able to do a near frictionless transfer. so So you see these issues. Obviously, there's other issues. And you mentioned like cross-chain things. Yeah, of course there are other issues, but it is striking that this technology ah is focused so precisely on the frictions that
00:37:28
Speaker
ah happened with kind of centralized exchange. By the way, I just want to briefly as a side comment put in, you know obviously, there's there's a lot of really interesting work happening in the world of blockchain right now. And I think some of them are exactly right on this this dimension that Joel and Cam, you both were sort of touching on here. right So for example, we've heard references to 12-second block times.
00:37:51
Speaker
but a lot of blockchains like avalanche for example have faster block dimes and now even in the ethereum ecosystem a lot of the activity is taking place on layer twos that are faster and on top of that um when you're thinking about sort of uncertainty about trade prices and so on that was being referenced earlier if you're doing it on something like a first come first serve layer two like arbitrum.
00:38:15
Speaker
i'm not sure how how I'm not sure if those problems are quite as ah significant as they used to be. and i and i And so I think this is actually kind of a very interesting point and one that is very ah current because yeah a lot of the stuff that we see now is actually sort of attempting to
Risks and Innovations in Decentralized Exchanges
00:38:34
Speaker
address. And I think Joel, to your point, it's not fully it hasn't fully addressed it.
00:38:38
Speaker
but it But it does seem like the like there is movement in that direction, I think. Yeah, and if I if i may also jump in for one second there for Hart, I think one one of the things that I hear from what you're saying is it is actually a moving space with lots of things happening. And since we're on the topic of regulation, general you can I think this' there's there's a general issue, which is that there is always a risk that regulators start to you know address a problem too early where there's a technological but you know solution possibly that will overcome it. um And the problem with that is that you lock in a ah law which is there forever and that kind of constrains what can be done in the future. So I'm just going to throw this out there because I think that's kind of an important thought and something that we you know that needs to be kept in mind when we think about involvement of regulators in this space.
00:39:30
Speaker
Yeah, I think this ah issue is fundamental that there are some obvious issues, some obvious frictions that exist in decentralized exchange right now, ah but they're recognized and the community is working on solutions.
00:39:46
Speaker
And it's much more efficient to have the community propose a solution than for the regulator to interfere. And often the regulator is not as informed as the people that are actually in this space ah developing ah new ideas.
00:40:04
Speaker
And the regulator does something that really sets us back, sets the innovation back. So so it is important, and I think our research paper is helpful on this in kind of detailing what are currently, and this is really important, the word currently, ah some of the issues with decentralized exchange.
00:40:27
Speaker
And then, ah well, what can we do about those issues to kind of mitigate ah those problems? ah So I think that that includes a regulatory and dimension, but that's not the only vector that's available.
00:40:43
Speaker
It's actually very interesting. Can can I um maybe maybe ask a broader question? I'm going to direct it to Joel um because he's been working with the SEC and the CFTC and they're like, can you just very briefly outline to us of when it comes to the regulation of trading and markets, what are the major questions that they worry about and and where do they feel that they need and why do they feel that they need to say interfere with the market operation?
00:41:11
Speaker
oh ah Yes, first of all, I must say I have worked with both the SEC and the CFTC in the past on matters related to traditional markets, absolutely nothing related to crypto or decentralized finance.
00:41:30
Speaker
ah My background is traditional markets, and that's where I feel I could feel i can represent their viewpoint fairly accurately. So ah first, all financial regulation, ideally, we would like it to be functional.
00:41:48
Speaker
That is, if, for example, you are an intermediary of some kind taking deposits and making loans, it should be the same functional regulation, whether you call yourself a bank,
00:42:05
Speaker
um a lending platform or a savings and loan institution. So ideally, in when we economists dream up regulation, it's functional regulation. But as a practical matter, functions are often um ah ah arise or dealt with in specific institutions. So most institution, just practical necessity, most regulation is institutional.
00:42:39
Speaker
And this is where a ah market or a community that is very much in flux, like decentralized finance, it hasn't yet had the time to develop stable institutions. So when the regulators, I i think, reach for something to try and get their hands around, they find they're you know grasping thin air. Now, what do they care about?
00:43:09
Speaker
um Certainly um ah um ah financial stability. um Certainly investor protection.
00:43:24
Speaker
That is, um are the investors getting the information they need? And are the trading and custody institutions really working on behalf of those ah investors? ah So they care about investor protection. They care about release of information, market efficiency.
00:43:48
Speaker
capital formation. We haven't discussed that really because with cryptocurrencies it's you it brings in valuation issues that I'm not sure we're ready to address. But um ah if if you think about the record of traditional markets in doing the things that we think that ah markets should do, raise capital, do intergenerational transfers,
00:44:18
Speaker
separate ownership and management, um ah transfer risk. ah All of these things, the traditional financial markets yeah are, I would say, very highly evolved, very well engineered um internal combustion engines, if you will.
00:44:40
Speaker
And ah they function extremely well. Now we're making a transition to decentralized finance. And um institutional regulation of the sort that we've had in the past is no longer as clearly applicable. So we're having to rethink it. um But Fahad.
00:45:06
Speaker
Yeah, can I add two streams of questions that came to mind? um ah Let me just start with a one of them because they're not too related. um So you laid out all these things that I guess regulators want financial markets to do.
00:45:21
Speaker
ah As economists, though, you know we tend to all of us tend to think sometimes differently than regulators in terms of like a single objective function. And um you know there might be certain ways to say maximize welfare that may involve a bunch of different things. um But normally, we think of things like maximizing welfare as sort of a single objective.
00:45:44
Speaker
right um All of these things that you laid out though, like do they fit into some kind of paradigm like that or is it more of like an ad hoc? Yeah, we think that markets should be efficient and that they should i encourage capital formation and so on. like Is there actually kind of a unifying principle that drives these or are these themselves things that just ah the regulatory community takes as given as things that markets should do?
00:46:17
Speaker
um Well, for that Fahad, we'd have to look at, at least in the case of the United States, the authorizing legislation of our securities laws. And in many cases, things like capital formation are explicitly mentioned.
00:46:38
Speaker
And even when they aren't, things like market efficiency, market efficiency plays a very important role in ah securities markets ah ever since the Supreme Court decision, Basic v. Levinson.
00:46:55
Speaker
ah And it's not an abstract idea. It's the connection between prices and information is, it's a tenet now, a part of securities law. Actually, wait so then if I may, because this actually kind of touches into what I was the other question I was thinking, which is when you're talking about markets,
00:47:18
Speaker
um There are, of course, different financial markets, right? Like, one way to think about it is that, okay, there's an equity market, there's a bond market, and the high yield market in bonds is very different than the investment grade market and so on. And so when you're talking about achieving certain objectives, it sounds like they're sort of more relevant for certain financial markets relative to others. And part of the reason I'm asking even the stream of questioning is that Some people would say, well, the crypto market is just kind of a fundamentally different market. And so maybe it should not be, you know, um maybe it should not have to answer for all of the same things that, say, the equity market does. So I guess, first of all, could you clarify when talking about those things?
00:47:57
Speaker
What are you referring to when you refer to a financial market like you're going to particular ones or some sort of umbrella across all all of them and on top of it how do those things then relate to specifically the crypto market in the sense that does the crypto market should is there a reason why it should inherit all of these requirements.
00:48:17
Speaker
Okay, that's an excellent question.
Regulatory Needs for Crypto vs Traditional Markets
00:48:21
Speaker
um ah First, was I speaking about any kind of financial market? No, not not really. There are things that we define as securities and God help us if we go down this rabbit hole because it's not going to i at at least ah I can mention the Howey test and whole you know whole rooms full of lawyers well will swoon or start fighting one or the other. um But i in the case of crypto, I would say at this point, the most the the principle that seems to be most at work um is investor protection.
00:49:07
Speaker
And we have had ah ah enough evidence with existing, you know ah with with FTX, with Binance,
00:49:22
Speaker
and and so forth, to know that there is not always um it It's not as clear ah how to protect investors in these markets as it is in traditional ah markets.
00:49:40
Speaker
so joe joe do you mind if i just interrupt for the the listeners i will just so be super clear here ah ftx and finance are centralized exchanges that happen to be dealing with some decentralized tokens and and other tokens. yep so So most of the kind of regulatory focus has been on centralized entities in this crypto space.
00:50:09
Speaker
ah Whereas what we're talking about in decentralized exchange is something fundamentally different. There's no institution. It is an algorithm. You don't necessarily even know who deploys the algorithm.
00:50:24
Speaker
That is that is that's absolutely correct. I'll cede the point to you there. um it is um If I were a regulator though, the experience with these things trading on centralized exchanges, um it it does not Let me put it this way, it raises concerns about decentralized exchanges, even though that you're absolutely right, the history is just purely ah ah the explosions, the blowups have happened on the centralized exchanges.
00:51:07
Speaker
Okay, so just in terms of um, the first part of your answer joe part of what ah I think I was uh Understanding from which and so if you can correct me if i'm misunderstood. Um it you referenced investor protection as being sort of Uh, the big thing at least right now is well it it it it's an obvious one Right, but but but in that context though, it sounds like you're saying that the regulatory apparatus is a bit, uh, uh ad hoc in the way that like people get ripped off and so, oh, okay, so we need to step in to stop people from getting ripped off. And obviously there's a bit of, I think part of what Cam was pointing out is that there's sometimes not full knowledge about what they're actually looking at. Like something bad happens at FDX and they think they have to regulate DeFi and don't understand that's not DeFi.
00:52:00
Speaker
but um But nonetheless, going back to sort of the things that regulators are trying to achieve, is this more of an ad hoc process? Because I think people sort of in the crypto world, to some extent, struggle with dealing with the regulatory community because they don't quite understand the thought process.
00:52:15
Speaker
and by the even you know myself as an Economist in a room full of economists. I have to say like I also find myself Struggling when I talk to regulators because as I alluded to earlier, I don't think they think like economists I don't think they think about like what maximizes welfare and here are the things that maximize welfare They it seems like more of an ad hoc process. So I guess first of all, is that if you think that's a fair characterization I I think it's a fair characterization, but remember they they do not They have a very limited ability to craft laws.
00:52:51
Speaker
ah they they ah They can issue regulations, but very often the SEC and the CFTC find their regulations being overturned in the courts. So um at one at one level, we can say, look, we need a thorough economic analysis here.
00:53:15
Speaker
and If you go back to the original authorizing legislation of the 33 and 34 Act, there was a process that went on there and ah ah a fair fair amount of, ah I would call it economic analysis, went into it.
00:53:36
Speaker
But the political climate right now is such that um we cannot or or the regulators feel they cannot do a first principles dive at this and they're limited to the tools that they have. And I think frankly that puts them in a position that they are not entirely comfortable with.
00:54:01
Speaker
Asserting, for example, that a decentralized exchange really is an exchange and really can be regulated with the existing legal apparatus. ah i i like I can't imagine they're very comfortable arguing that. But the way the world is now,
00:54:24
Speaker
They really don't have a choice. They're going to war with the technology that they have. And that technology, I guess, um a lot of this technology was specified before we even had computers.
00:54:41
Speaker
And I do think, Joel, you're making an excellent point that I know people criticize the regulators. They're engaged in a whack-a-mole strategy. So regulate ah by enforcement. After Chevron especially, ah it's going to be very difficult for them to make any ah policy ah that won't be challenged in the courts. So it's not just the regulators. I think we also need to focus on the policymakers.
00:55:11
Speaker
We've got laws from 1933 and 1934 that have not been refreshed to the modern day. And of course, that refreshing ah poses some risk in itself. So it's not just regulators, it's the policymakers also.
00:55:29
Speaker
And to that to that end, I think and it's it's good to see efforts like the Lummis-Gillibrand proposal and other proposals where they have tried to at least set up a general framework where the details of regulation might be ah might be hashed out in some kind of sensible framework adapted to these assets rather than trying to shoehorn them in to regulations for which they were the regulations were never designed. Out of curiosity, are there any useful analogies ah ah that people in the crypto world can use from prior financial markets that sort of had to be, let's say, ingratiated into the regulatory architecture?
00:56:22
Speaker
um That could again help think about how how this might evolve Certainly, you know, we could we can um ah the The kinds of securities that we're working with ah are very ah That we're work with today we're not part of the original authorizing legislation um ah a favorite example that Rachel Barnett, who's a an attorney who works for IEX,
00:56:58
Speaker
ah she points to the asset-backed lending market. And this really develop as a um it developed within the current regulatory framework, but by allowing existing laws to really, I would say, adapt.
00:57:20
Speaker
um And ah she makes a pretty good case that this is a ah a template, if you will, for um regulatory innovation to encompass crypto. Now, it's not a perfect analogy. Asset-backed lending is an institutional market. Crypto is very, very ah retail.
00:57:49
Speaker
um And that brings with it, you know, a different set of players and a different set of problems. But in answer to your question, yes, the the attorneys are looking around in all kinds of places for things that might be adapted to deal with crypto. um Another example ah is ah over the counter markets.
00:58:18
Speaker
Right. There are regulations dealing with ah OTC markets as opposed to exchange based markets. And um ah there are some crypto products that have evolved as over the counter securities. but So are there um markets which similar to crypto had um a difficulty with, let's say, touch points fraud that that regulators might have. right So like the classical problem, which I think we'll get into here with crypto, is who exactly are we regulating anyway um from the regulatory perspective? like who who who Who is who who is that it that you are supposed to regulate? um Now, the closest thing I can think of, naively, without actually you know having the sort of knowledge of financial history that that Joel and Cam, you both have,
00:59:17
Speaker
is I think but you know we live in a globalized world. And if we're talking about, say, US regulation, there must be extents to which US regulators have difficulties accessing entities outside of the US, particularly, I guess, in more hostile parts of the world. Is there anything that um that is there is there any attempt of the US to regulate in that context where we're getting beyond US borders that can tell us something about um how regulation would happen in this context, given that again, US s regulators might have issues. um i you know In this case, even identifying entities, as Cam was saying, like you're not you know they they're not basing anywhere really, ah it's code. So
01:00:11
Speaker
So can I sharpen the question to Joel? And and that is that I kind of see like OTC trading as as relatively decentralized. um And the so regulatory environment, to my knowledge, maybe I'm wrong on this, within the US, deals with OTC trading that involves at least one US-based counterparty. ah Whereas in the crypto space,
01:00:40
Speaker
This is a global technology that ah where you've got a ledger on computers all over the world. And it just seems really difficult to use that historical analogy on the situation we have in decentralized finance.
01:01:00
Speaker
Well, I agree with you, Cam. ah But there, the relevant law, I think, is not securities law or commodities law. It's banking law. ah It's the anti-money laundering and know-your-customer type things. And yes, this ledger is ah it's worldwide. Multiple copies exist.
01:01:26
Speaker
But it is not possible to authoritatively connect ah those ledger identities to any kind of real person, real country, or real institution. Sometimes you can do it, sometimes you can't. And for banking authorities to throw up their hands and say, we've lost control,
01:01:54
Speaker
is um ah i I think it's beyond our borders, we can't do anything. i don't and i don't I don't have a practical solution here, but the cost for abandoning those laws as unenforceable is i think it will be pretty high so so this does point to one of the issues with decentralized exchange so
01:02:26
Speaker
there are some some downsides and one obvious downside
01:02:38
Speaker
the person interacting with the decentralized exchange. ah Indeed, it could be an address that's sanctioned by um ah yeah Yes. And i I think it is a it's ah very strong tension between the DeFi community and give the traditional regulatory community.
01:03:06
Speaker
um that ah And it shows up in the language, you know, to a DeFi person, a system, one of the beauties of DeFi is that it is censorship resistant. A transaction cannot be stopped. It cannot be definitively traced afterwards.
01:03:29
Speaker
this by and large in the DeFi community is viewed as a virtue. And indeed, ah there could be ah somebody that's proposing a block ah could choose to censor certain addresses.
01:03:47
Speaker
So it's it's their choice to actually do that. They see a list of sanction address ah addresses, and they choose not to include those in the block of transactions that they propose.
Financial Inclusion and Ethical Considerations
01:04:03
Speaker
However, the problem is that there could be somebody else out there, ah perhaps offshore, ah that decides to include.
01:04:11
Speaker
And it's near impossible ah to filter out all of these sanctioned addresses. Yes. So i to bring it back to to regulatory issues, I think we have a history of innovation in, say, ah commodities markets, derivatives, and ah securities, stock index futures being one of them.
01:04:40
Speaker
where a regulatory philosophy evolved and authority was shared between the CFTC and the SEC. So I don't think, I believe it's possible for those two agencies to compromise, find common ground, and maybe find common ground when it comes to crypto. I think the interface with the banking regulations and laws is going to be much more ah much's much more difficult.
01:05:13
Speaker
So I'm going to just throw something in there. Maybe this is a bit of ah an off-field idea or or thinking. But if you if you take a really broad picture overview here, a lot of what we're talking about in the world of finance, when it's safe, for instance, when it comes to ah individuals, is that in order to participate in the financial world, when it comes to financial institutions, for instance, you need to be in some form ah authorized to do so. but You need to go to a bank at a bank account. that's You need to get authorized.
01:05:43
Speaker
If you want to make a transfer or you want to receive funds from somebody, you need to be authorized. um This is very un-American in a way, right? Because if you think of the European world, if you wanted to run any kind of business in the old-fashioned European world, you needed a license. You want to become a baker, you need a license. You want to do something, you want to be farmer, you need a license. You can't just do what you want.
01:06:04
Speaker
People came to the US and kind of the spirit of the US is you can do whatever you want unless you impose a cost or a problem on others. But the banking world is really quite different there. right So everything is centered and every way every thinking that we have and a lot of the discussions that we have around is based upon the idea of you can only do this if you're allowed to do it.
01:06:26
Speaker
um There's a good reason for it and there's good arguments in favor of it, as there were good arguments for you know not allowing everybody to bake bread. um It's just a question of in this new world where you have ah you have a system, as Cam pointed out, where anybody can play, yeah anybody can create a new ad address and and receive funds and send funds, is this really even as an A is a question of it's manageable, B is it desirable and C is there maybe ah a different world, a different way how we can do it so that instead of you know trying to as you say shoehorn everything into our existing world, um you know take the reality as it is and find a different way how you can achieve the same policy objectives. I don't have a good answer but maybe you do.
01:07:13
Speaker
Yeah, I think this is a fundamental point um that this is a technology of financial inclusion. It's a technology of financial democracy. It is a technology of transparency ah with the goal of reducing frictions, eliminating middle people, giving the people that interact in the space a better deal. This is fundamentally a nonpartisan ah issue also.
01:07:42
Speaker
So both Republicans and Democrats ah embrace those values. So this is such a positive thing. However, there are at this point in time some negatives. And with any new technology, there will be some downsides. And the question is, are those costs greater than the benefits? And I don't think so.
01:08:09
Speaker
And what we need to do is to be very careful to let this play out ah organically, allow for some time for the community to fix or to mitigate ah some of these problems without the heavy handedness of a regulator ah who might not be fully informed on the space doing something that sets this innovation back.
01:08:38
Speaker
where we don't realize some of the fruits of this great idea that ah is disrupting our financial system.
01:08:49
Speaker
Andreas, that is the last two minutes of your podcast, right there, in what Cam just said. care Yeah, that's true. That's definitely fine. but But I want to actually, you know, a jive of that for one second, because in your paper, you actually have a particular segment where you discuss who to regulate. And and in some sense, one of the entities that you're that you're basically describing there is the user.
01:09:14
Speaker
Now, no regulator on the planet wants to regulate the the user because, I mean, that gets very close to police work, essentially, because you basically have to regulate the populace. The reason why regulators can actually do what they do is because there are institutions that they can regulate, so they can pass on some of their some of the duties to somebody else who who is has more has the real customer-facing business, which is not the case in the blockchain world, right?
01:09:41
Speaker
so maybe um Maybe if we can take one step back and actually just address this question of in the next world. who would you actually regulate? Who would you have to regulate? Who would you want to regulate? And who can you regulate? I think this is, so, and then if we can break this down, because we had a lot of different parties that we discussed. We have the creators of a DEX. We have the ones that operate a DEX. So the operators in the blockchain world would be essentially the validators. And then you could push this further and say, well, you know, there's builders and searchers, but that gets a little nitty gritty. And then we have the users. So,
01:10:19
Speaker
go yeah let Let me talk about like two of the three. So you mentioned the users and it really doesn't make any sense to go after the users. Indeed, if you look at the motivation for the 1933 Act, ah it was to protect ah the investors.
01:10:39
Speaker
so So to go and try to sanction people for using this technology of financial democracy and and dot, dot, dot, it doesn't make any sense whatsoever. ah Number two, ah there are ah certain organizations called labs usually that are supporting um a series of DEXs and think of Uniswap labs as an example.
01:11:07
Speaker
And what they do is offer improvements in the technology the decentralized exchange technology. So there's version 2, version 3, version 4, Uniswap X. So all of these are pushing this space forward.
01:11:26
Speaker
And to go after ah the lab would effectively shut down ah that lab. And indeed, ah Uniswap Labs was served a Well's notice um by the SEC. And in my opinion, going after the lab actually increases the risk.
01:11:46
Speaker
it It goes in the opposite direction. If you don't have ah people focused on these algorithms, trying to improve them, trying to fix or harden them from attack or vulnerabilities, ah that that that actually goes against what the regulators want to achieve. So it's an action to me that makes no sense. It's counterproductive.
01:12:13
Speaker
productive but Actually, I want to chime in on on something there, too. which is um i mean this is This is a bit of a controversial topic, but about a year ago or so, there was a there was a new draft for regulation of how it actually defined an exchange and and who's actually in charge and responsible for it. and that The text of the of the proposal read effectively that the creator of of a platform would be potentially on the hook, so that means the one who develops the code ah could be on the hook.
01:12:43
Speaker
which if now speaking to all of us here together, in in some sense, if one of us would be in some form engaging with the crypto venue or actually has research on it and develop some form of crypto venue, which is then the basis for a code that is being written at some point, we're developers and we could actually be on the hook. So literally an academic.
01:13:03
Speaker
could be on the hook because this the description of what the SEC wanted to capture is incredibly broad. And this really, as you as you say, Cam, this actually raises enormous questions actually way beyond just ah security and risk, but you know first amendment and so on and so forth, right? I think that's pretty hypothetical. Let me give you a sort of a counter example.
01:13:26
Speaker
So about ah three or four years ago, there was a spoofing case um involving, ah I believe it was stock index futures. And the person charged was the programmer who developed the code that was going to enable these spoofing orders, ah manipulative orders, to be entered.
01:13:52
Speaker
and ah the the ah the the person who did the trades was ah ah convicted of spoofing, ah but the computer programmer was not. And at the time, the analogy was, um if if if the getaway car was a Chevrolet, do we go after General Motors in a bank robbery?
01:14:21
Speaker
And the answer the answer is no. So I i i think ah yeah when we're sort of saying, potentially, who could intellectually be considered responsible for these DEXs, it is, I'll admit, pretty broad. um And and like i probably everybody who's in on this podcast and probably half the audience as well.
01:14:50
Speaker
um but On the other hand, i the way i'm I'm familiar with that passage in the SEC's writing, and they they do sort of say, it's true that these things are decentralized, but they don't come into existence in the absence of human agency.
01:15:14
Speaker
All right, so there there is a ah cause and effect here of people bringing them into existence. And um I sort of view this as a, um and it's it's not a threat of imminent prosecution.
01:15:34
Speaker
But it's more sort of a statement that, hey, ah these things do not arise in a vacuum, and they don't exist outside of the real economy. Joel, can I just ask a ah concrete example sort of i think to the point you're trying to make? so I think part of what you were saying is that ah Yeah, but you know a car company creates a car. They're not intending the car to be used for a theft. And so any sane person would know you're you're not going after the car company in that instance. But in the world of crypto, I think we get into sort of gray areas owing to the fact that sometimes the regulators
01:16:11
Speaker
aren't very clear going back to what I was saying earlier, but what the objectives are. And so I'll i'll give you a concrete example. Imagine a developer were to create a hook on Uniswap v4 that would make it easier to quote sandwich attack or, you know, let's, let's, if if I may use the more colloquial term front run and simultaneously background another transaction.
01:16:33
Speaker
For the purpose of raising revenues that are then distributed, however, so in other words, the the hook developer in his own mind has a benevolent use here. Maybe even the the the victim of the sandwich attack doesn't actually face and gets better execution because of the way the design of the hook is in totality, right?
01:16:54
Speaker
But nonetheless, in order to achieve that, in order to make this option mechanism more efficient, the hook makes it easier to front run somebody, right? um I actually don't know how a regulator would react to this, in part because, it's you know, ah different people in the legal community that I've experienced react differently to it. um So in that case, is there any risk to that developer? And and I think part of going going to maybe what Cam was getting at earlier is that If you do end up sort of affecting development ah in this space, you could even do things that sort of on net reduce welfare in the long run. Like it's not clear the hook that I just described is actually um has a net negative effect on welfare. In fact, it probably has a net positive effect on welfare. But nonetheless, you could see ah ah you know somebody from the legal community saying, no, you know this is just this is
01:17:45
Speaker
transparently, um making it easier to do things that you should not be making it easier to do. All right. I i won't to i won't um address that issue specifically, but I'll bring up another example that I think is related. Our traditional financial markets have market makers. The New York Stock Exchange for many years had dealers who were known as specialists.
01:18:10
Speaker
And at one point, the specialists were a group of them ah were convinced of were were ah indicted on grounds of various misdeeds. And um one of the ah lines of defense that was considered was this.
01:18:31
Speaker
We expect a lot of these dealers. We expect them to be present in the market all the time providing liquidity. And in exchange for shouldering these burdengeont burdens, we're going to allow them to effectively tax the customers by engaging in certain trading practices that are not, um and the brief in the broader sense of things, considered legitimate.
01:18:58
Speaker
So when economists recognize this as kind of a cross subsidy and therefore probably inefficient, but under circumstances, a certain circumstances, it might be kind of attractive. um and And this I would say for i it's It's an important part of traditional traditional financial markets. It has not yet arisen in DeFi or crypto markets that I'm aware of, but it's the idea of an agency responsibility. So the New York Stock Exchange and the clearinghouses, they're not just a collection of rules. They are collection of of sort of um
01:19:47
Speaker
ah duties that um ultimately change of responsibilities of acting and doing in a manner that's sort of the right way to do things. um And these agency relationships now they are institutionalized. They don't exist in the crypto community.
01:20:12
Speaker
to the best of my knowledge. So when when you ask ah sort of if you put a hook in, um how do you how do you decide whether that's manipulative or not?
01:20:25
Speaker
um and And in some sense, the hook is purposefully manipulative. That's the point of the hook. And I think the bigger issue here is that, um like, if I followed your and ah your example, in that case, you were still basically talking about these ah market participants doing some things that even they might say is bad. And it's like, but we need market park to you need we need these liquidity providers as a whole. So we're kind of okay with them doing a little bit of stuff that that everybody agrees is about. The problem with with the what what I was describing, though, is that
01:21:01
Speaker
the hook developer doesn't think the thing that the hook is doing is bad. in fact it made mean know but In fact, the person who's doing the trade that is getting sandwich attacked might also say, this is not actually bad. This whole thing is set up to make the whole system better from a welfare perspective, even it might be the case that it is actually better.
Future of Regulation in Decentralized Finance
01:21:21
Speaker
And so I think There is a little bit of blood for this way. I feel like there's a little bit of a risk with some of the legislation that Andreas was alluding to in this setting that is more binding than in the traditional setting, precisely because in this setting, it's not always even clear whether the action is, let's call it good or bad in a simplistic sense, right? um And I think I see that as a distinction. And and i'm i'm not just I'm not disagreeing, by the way, that
01:21:52
Speaker
um There aren't things that people do that are bad, right, in this setting that that you would want to disincentivize. I do think, however, this this community tends to be very inventive. So they occasionally come up with ways of doing things that might actually be advantageous. But nonetheless, from a very rules-based approach, which I think the legal community tends to take ah take a very rules-based approach, from that perspective, it may cross the line at at some point or the other.
01:22:20
Speaker
um And it may not even be clear if it's crossed or not, right? Like I characterize the sandwich attack as front running and back running, but there are people who will argue this is not actually front running because front running, they will define as a situation where somebody has the unique ability, or at least only a few people have the ability to do this, but in decentralized exchanges,
01:22:40
Speaker
you know, I can front-run people just as much as anybody else can, so maybe it's not front-running in the in a legal sense, but that's just a whole lot of ambiguity and and that doesn't really help when it comes to the tech sector and trying to come up with innovative ideas, I guess. Yeah, so can I jump in here because I think that there's, I want to draw a distinction and I totally understand ah Joel's argument in terms of the traditional specialists that they get like an extra return ah to bear this risk that they have to provide a liquidity even in kind of bad times.
01:23:17
Speaker
ah When we're talking about like front running and back running or sandwich index, it's a totally different situation. so This is a situation where a customer puts an order in to buy something at a certain price with some slippage, and then given that transaction sits in like a memory pool, people can see it.
01:23:40
Speaker
that there's a possibility of buying ahead of that transaction to push the price just a little below that slippage and then to dump the asset after the consumer transaction. So what this does is it makes ah the execution of the transaction worse for the buyer.
01:24:02
Speaker
So it's a cost, it's a friction. And this ah profit that the sandwich attacker makes, that doesn't go right now to the liquidity provider or to the person doing the order.
01:24:17
Speaker
ah So the analogy to the specialist just doesn't work in this case. And I think that this is just like a friction in trading that exists right now. So I put this on the negative side. And we could argue whether this is traditional front running or not. And I think that the actual ah what we call it is irrelevant.
01:24:41
Speaker
the The relevant point is that the execution is degraded as a result of this. And what do you do about it? And I think the most natural thing that will happen in this highly competitive market is that there ah these profits will be bid away and redistributed to the users of the DEX. I think it's unlikely that a regulator can do much about this.
01:25:10
Speaker
um So on this note, actually, I think there's a bigger question that we can ask here. And and I think this is probably also something worth considering, which is this is at various spots in our conversation, we came up with that there is some self healing or, you know, um If you want initiatives by the DeFi community, there is new technology being developed that addresses and mitigated a problem. And oftentimes, and you write this in your paper too, is there's a lot of risks that we actually don't know yet about because we haven't seen them yet, right? They haven't materialized. But the the community as a whole actually tries to to address it and and fix it. And I think one of the cool things about this space is because it actually is
01:25:51
Speaker
you know um Obviously, people have money in it, but it's really not very important for the for the financially for the financial world as it is, right and for an economy as as at this moment. so It's almost like an experimental lab where people play with real money, but you know we figure some stuff out. and Actually, I would argue it gets better over time.
01:26:09
Speaker
so um So there's two things here. there's is There's essentially three things that you can have in the world. You can have everything is sorted up by market forces, which is in some sense where this is how this DeFi world works now. You could also move in a direction of self-regulation. And you know Joel also knows everything about that, right? So FINRA is a self-regulatory body, if you want, and they play a really important role. And then you have a real government control in this space, which I think as we as we discussed here is actually quite difficult in the cross-border world, right? So where do you think where where do you think this is heading? And and you know to what extent do you think there could be self-feeding resources, self-regulation, and then when when is actually the government really needed here? Yeah, sure. So just kind of following up on what I was saying, that
01:27:00
Speaker
aye As liquidity increases, as this space becomes more prominent, ah there will be forces that push us towards more efficiency in execution. So we see the benefits of cutting out the middle people going from centralized exchange to decentralized exchange. We are at an intermediate spot.
01:27:28
Speaker
And what I believe is that some of these problems, especially focused on kind of the quality of execution ah in in terms of the so-called front running and back running, those will be naturally mitigated in the next ah couple of years. So some of these problems will ah be mitigated naturally. Will they completely go away? No.
01:27:55
Speaker
But again, as economists, we need to take a look at the overall benefit ah versus the cost. This is not a risk-free technology. It offers a lot of benefits, and there are some issues in the short term, ah but I think that we need, on balance, to to look at the benefits ah relative to those costs. Any regulatory approach.
01:28:19
Speaker
that tries to eliminate all of the risk is going to kill ah innovation in the US economy. There are certain things that I think are really vexing, and I just don't know how to deal with them where you've got sanctioned entities that You might not want transacting in this space, and I just don't see a way around that. um Luckily, at least at this point in time, that's a small amount of what goes on ah in this space. I think that's ah that's a very ah positive sentiment, and it's it's one vision of the future that I i hope. That's how the community evolves.
01:29:06
Speaker
um The idea of extracting value and redistributing it to ah those who are affected,
01:29:18
Speaker
there is ample antecedent for this in welfare economics as well. ah Take something like pollution, do you tax the polluters and then redistribute the wealth to ah people who are ah adversely affected?
01:29:36
Speaker
um As an alternative, that would be a market-based solution as an alternative to prohibiting the pollution in the first place. The economists do not have a final answer to this, and and neither do I. And yes, there is a certainly a potential cost to shutting down innovation.
01:30:02
Speaker
And frankly, it's such an exciting ah idea and exciting area to think about. um I don't think anybody wants to go completely in that direction either. um at the At the same time, everybody, I think, is struggling for a balanced path.
01:30:24
Speaker
Yeah, um so I think actually both of your statements here are actually make a very good conclusion to the podcast um in terms of ending on a positive note and seeing how how there may be a path forward.
01:30:38
Speaker
um Maybe at this point it's also useful to to point the the listeners to your particular paper which is available on SSRN. ah We will be posting I think in the description of the podcast a link to the paper and I recommend that people read it. um I've read it and I think it not only summarizes very nicely how DEXs work and what problems arise but also what the complications in any regulatory approach are and I think also one of the things that that i I find really fascinating about this discussion is ah Cam and and Joel and Fahad you actually all come from different perspectives and you have different views of of regulation regulatory space in the path forward and it it is reflected in the paper um and so I hope that many people who are interested in space will read it.
01:31:26
Speaker
ah can and ands Can I just mention that one of the issues in this space i is that it is complex. And if you think of historical innovations, um this one is probably one of the most difficult to understand. So I think it's incumbent upon us as academics.
01:31:50
Speaker
ah to have a positive influence on the evolution of this technology. And that motivates kind of what we're doing. And it is a challenge. So if you are a user of a technology, you should understand ah what you're using. And if you're a regulator of this technology, you need to understand. So it's important to invest the time to actually learn about some of the complexities and the challenges and the risks of this technology. ah That's the only way, in my opinion, that we move forward very efficiently.
Conclusion and Additional Resources
01:32:30
Speaker
Yeah, that's very well said. Thank you so much, Cam. And you know try to get the information as a regulator, in particular, as a policymaker from the people who are engaged in the space. That includes us, by the way. Not that I want to self-advertise, but I think there are a lot of people that have things to say that are have an unbiased view in the world.
01:32:48
Speaker
All right, maybe with that, I'm going to conclude Cam, Joel, Fahad. Thank you so much for your time on this topic. um And this this has been a great experience and I think I hope the listeners will enjoy this podcast. Thank you.
01:33:05
Speaker
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