The Power of Markets

In the past few years we’ve seen the emergence of cryptoeconomic primitives using markets. Instead of relying on an individual or a group, these systems use decentralized market mechanisms to achieve their goals. Two examples I’ll explore here are curation markets and prediction markets. I believe these are the tip of the iceberg and that we are going to see a flood of market-based solutions in the future.

A few innovations are enabling this trend:

1. Smart contracts let us create trustless coordination mechanisms (example: token curated registries).
2. Standards that allow anyone to deploy their own cryptocurrency or non-fungible token (example: ERC20 & ERC721).
3. Infrastructure to trade the above assets (example: 0x protocol & OpenSea).

These are building blocks that we can use to create new markets. Taken together, we can design systems that use markets to produce outcomes that are not achievable otherwise. Fundamentally this is an important development because it allows humans to coordinate in new ways. I’ll explore markets and two of their applications in this article.

Markets as a way to coordinate

Markets are not simply places that facilitate transactions. When we interact on a market we coordinate with others and together achieve outcomes beyond our individual abilities. In a market coordination is decentralized; there is no central authority that tells people what to do or when to do it. Participants are free to act for themselves as well as join and leave as they please. When markets are done well they are powerful tools to meet gargantuan challenges like addressing climate change and improving healthcare.

At the core of markets is not only decentralized decision making but decentralized flow of information. Participants in markets evaluate the information available to them and use it in their self interest. Other participants see these actions, learn from them, change their priorities and preferences, and in turn future transactions are influenced. Economist and Nobel laureate Friedrich August von Hayek wrote:

“The market is essentially an ordering mechanism, growing up without anybody wholly understanding it, that enables us to utilise widely dispersed information about the significance of circumstances of which we are mostly ignorant.”

That is not to say that market participants are required to intake and properly process all information. On the contrary, markets work precisely because no one can know everything. As participants learn new information they act accordingly and others take this as a signal. Some participants might have asymmetrical information, that is, information others are not privy to. The actions of these participants send valuable signals to the rest of the market, and in turn the market learns and updates itself. For example, it’s common practice to watch the buy and sell signals of company insiders who have access to key information before it’s made public. It is also the reason why it is so valuable to have a well known cryptofund invest in your ICO.

Prediction markets

Prediction markets are a great example to demonstrate the power of markets. These are markets created for the purpose of trading the outcome of events. The prices within a prediction market indicate what the participants believe the probability of an event is, ranging between 0 and 1. A price of 0.5 would indicate a probability of 50%. At the stated expiry date the price becomes binary, either 0 or 1, depending on the outcome.

Prediction markets use market mechanisms to aggregate disparate beliefs and information asymmetries over a single future unknown outcome. Participants share their forecasts of a future event by buying or selling a corresponding outcome. Pooling all of these together, we can come to a single “fair” price given the market participants’ actions. But not all forecasts are equal and not all forecasts have the same impact.

Those that have high conviction about an outcome due to their expertise or an information asymmetry have an incentive to put more money behind their forecast in order to maximize their payoff. Other participants will see these transactions, perceive their corresponding quality to be higher, weigh them more heavily than others, and adjust their own forecast appropriately.

Historically prediction markets, like Google’s internal market or various political betting websites, have been centralized. Inherent with this is a level of trust in the market operator to correctly resolve markets and not steal your funds. Moreover, centralized market operators can censor what market participants can trade on.

In contrast, Augur is an “open-source, decentralized, peer-to-peer oracle and prediction market platform built on the Ethereum blockchain.” Augur uses smart contracts (100 of them!) to create a decentralized prediction market platform that doesn’t rely on a trusted central operator. These smart contracts represent a clever series of mechanisms to ensure that anyone can generate a prediction market for an outcome, that the outcome is priced fairly, and the outcome is judiciously reported. You can read the details of how this works in the Augur whitepaper, but the end result is Augur allows people to trustlessly coordinate and predict the probability of outcomes. If Augur works at scale it will be a much better way of coordinating than its centralized counterparts.

Curation markets

Curation markets seek to curate information in an ecosystem. Ocean Protocol is using them to curate and value data sets and Relevant is using them to curate news. The process works like this:

• There exists an ecosystem with sub topics (for example a project and a list of proposals to implement)
• Tokens can be bought at any time at a price dictated by a smart contract
• As more tokens are introduced into circulation the price for them increases
• The amount paid is kept in a communal deposit
• At any time you’re allowed to trade in your token (decreasing the supply) for a proportional part of the communal deposit
• Tokens can be staked by users to sub topics they support, sending an informational signal

I’ve taken the outlines of this from Simone de la Rouviere’s article here. The core idea behind this mechanism can be surmised as the following: token holders have an incentive to curate the best possible feed because that will garner more attention to that feed. In turn, that will make their tokens more valuable as others seek to have their content in the feed and buy tokens to try to influence that process. Instead of trusting a single expert or a committee to curate this information market mechanisms are leveraged.

Imagine a Reddit that implemented curation markets at scale, where each subreddit is its own curated list. Users could submit content, participate in curating it and and others’ content, and in turn be able to monetize their efforts. Or playlists with thousands of users fluidly trading tokens and from that cacophony emerges a single ranking of songs.

Why is this important?

Today prediction and curation markets may seem like games. After all, they can look like glorified gambling or niche at first glance. But underlying these “games” is a powerful innovation: these markets allow disparate groups of humans to coordinate in new ways. No individual or group would be able to achieve the outcome that a robust decentralized market can. At best, we have centralized counterparties which are rife with issues of government regulation, censorship, or trusted third parties. That’s not to say decentralized systems don’t have their issues, but there are use cases where they are inherently better.

Coordination is foundational to society; it’s what make the world run. Even marginal improvements to how we coordinate can be immensely powerful, take for example the effect of mobile phones on the fisheries in South India. New ways to coordinate are transformative as they unlock entirely new design spaces. Think of all of the businesses integral to our lives today that weren’t possible before the Internet. That is why this is important.

Like the Internet, markets powered by cryptocurrencies will let us coordinate in ways that weren’t possible before. They will let information flow in new ways, enable new businesses, create communities, and so much more. That is revolutionary.

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