StockTrader in Cryptolandia an Analogy

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This short story intends to demystify some of StockTrader’s newest changes to fee mechanics so that people can have more rational discussions around StockTrader’s price. The illustration is an approximation of how StockTrader actually works but as with all analogies it has limitations and should not be taken literally.

Every month Cryptolandia had one or two new crowdsales for projects which intended to bring new services to the region. In late 2015 the StockTrader project decided to raise funds for a new crypto-stock exchange on Ethereum. This project would finally provide decentralized stock trading where every event in the world could potentially be converted into a stock trade. This excited some of the citizens of Cryptolandia a great deal. They had looked at the white paper for the project and had decided that it was a worthwhile endeavor.

Investing was a little bit different than simply buying stock in StockTrader however. To raise money for the initial construction of the platform StockTrader didn’t sell shares in the company but instead it sold something called a gun license. Because the SEC had created strict rules which governed the sale of a security this meant that gun licenses had to function in some way other than as a security. In the white paper a gun license conveyed to the user the right to operate on the premises of the stock-exchange as a security guard. It entitled its owner to an appropriate wage, necessary to keep the exchange safe, and it also provided fair penalties to discourage unlawful behavior (i.e. guarding incorrectly for financial gain). The white paper explained that this wage was produced by collecting a fee imposed upon every trade on the exchange and the total wages for all security guards would be equivalent to half of all fees collected from traders on the platform.

StockTrader would sell 100 of these gun licenses for 50,000 each and it would reserve 20 licenses for its own purposes. The crowdsale was a success. 100 gun licenses were issued to supporters and 5 million dollars was raised. One day after the crowdsale ended an enthusiastic StockTrader supporter Alice ran into one of her friends Bob and they had an interesting conversation.

Why People Were Really Excited About StockTrader

Bob: Hey Alice I heard you purchased a gun license in the StockTrader crowdsale is that right? Do you really think that was a wise choice? $50,000 seems awfully expensive. There seem to be a lot of projects in Cryptolandia these days which are quite ambitious. Do you really think the StockTrader team can pull this off?

Alice: Hey Bob. Good to see you. Yes I did purchase a gun license and I do think it was a wise choice. After all security guards collect 50% of all trading fees. Right now on centralized exchanges trading fees are anywhere between 3% to 10% which is crazy. StockTrader should be able to undercut all of these exchanges by offering 1% fees.

Bob: Hmm. That’s interesting. But Alice you will have to actually work as a security guard once the exchange starts running. Do you really want to do that?

Alice: I’m only required to work 20 hours every two months. Many of the security processes are automated so you really only need guards for a few of the critical processes that can’t be automated. If for whatever reason it ends up being more work than that I can always resell my license to someone else as I’m sure it will go up in value as the exchange handles more and more trades.

Bob: Maybe I should become a security guard once StockTrader goes live, if it goes live.

Alice: Yeah but if they actually manage to pull this off I think my license will be worth a million dollars or more don’t you think?

Bob: Wow that’s a little too rich for me. Do you really think they will go up that much in value?

Alice: Everything in Cryptolandia is going up so I’m sure when they launch in a year it will be worth a lot. I mean just think you can convert every event in the entire world into a stock trade. That is going to be amazing! From regular stocks, to sports betting and complex derivatives. Even if it only captures 10% of the online sports betting market place that’s probably 10 billion.

Bob: Hmm. Ok but I heard that other contracts can just leech off of StockTrader and eventually market competition could drive fees down to almost zero. After all some market makers are actually not trying to make money but instead are trying to extract information from the system. So long as market makers are the people who decide what fee you collect I’m not so sure you are going to be able to collect 0.5% off of every trade for very long. I mean even if you have 1 billion dollars in trades on the platform every year how much is your take if fees go down very low maybe 0.01%?

Alice: Well fees can’t go to zero because if that happened who would want to be a security guard? The prices for licenses would also go to zero. Crooks could just buy up all the gun licenses and then steal millions of dollars from the exchange. So since no one would ever want to trade on an exchange with no security this almost certainly means that traders should wish to avoid exchanges with fees that are too low since this provides no incentive for people to own gun licenses.

Bob: Almost seems like a perfect setup for a condition somewhat like tragedy of the commons maybe? I mean everyone wants to avoid paying fees but no one wants for there to be no fees. Also I assume that different market makers are competing on volume such that the market with the most volume can earn the most fees? What would hold fees up then? Anyone in the world can create a duplicate market with relatively little effort right?

Alice: Markets have creation fees and require validity bonds. The developers have stated that A fee of 0% is impossible because as the fee approaches zero, the validity bond requirement approaches infinity. Markets that expect to be popular and therefore have low fees will require a large amount of capital to create. In addition to this there is spam prevention measures which make the creation of duplicate markets more expensive. As market creators attempt to use predatory pricing to undercut each other they have to pay ever higher fees to do so.

Bob: Wow that is a good solution. So it seems like these StockTrader guys have really figured this stuff out. But you still haven’t answered one question which is how much do you really expect to make working only 10 hours every month?

Alice: I think that if StockTrader launches in Summer of 2016 initially there might be less than 100 million in trading the first year but you never know since they will probably launch right before the elections. But once we get to proof of stake and with better scaling solutions implemented on Ethereum I don’t think it will be long before we see 500 million to 1 billion in trading maybe by start of 2018.

Bob: So your take is 0.5% / 100?

Alice: No it’s more like 0.25% / 120 or 0.002% for a very conservative estimate.

Bob: So let me see what is that (breaks out his calculator) 500 million x 0.002% holy smokes that’s a million dollars a year.

Alice: That is a conservative estimate, it could be double that amount. And that’s just the beginning just think of how many markets StockTrader will undercut.

Bob: But wait a minute you only work 120 hours a year that’s like 8,000 an hour.

Alice: Well some CEOs do get paid that today in stock options and benefits. In Cryptolandia now anyone can become the CEO.

Bob: Seems too good to be true. I mean after all what does a security guard do for 10 hours a month? Just stand there right?

Alice: No we have to google the outcome of events and if we get something wrong then there are huge financial penalties. Some markets may only take a few seconds to decide but others may take a few hours of discussion, debate and research. Again remember that the cheaper it is to obtain a gun license and the less fees they generate the less security the exchange has intrinsically. If you want to have billions of dollars of trading you need to have gun licenses worth a proportional amount of money as a reasonable security mechanism.

Bob: Wow… well you seem like you really know what you are doing. Let’s talk again in a year.

After a year the project still had not launched. The launch was still expected to be 6 months or more away but soon the token would be tradable. At that time a few things about the architecture had changed but the fees had not yet changed. However in the spring of 2017 the fee structure was being reworked and by August it had become clear from short published segments on Stack Exchange and Reddit that the fee system was now very different.

How Does the New Fee System Work?

Previously the fees were expected to be directly correlated with the price of a gun license. Security guards were paid fees based on the volumes on the exchange. The total fees could be viewed as interest relative to a principle investment. So if a gun license was expected to return 1 million dollars a year reliably for several years then one could expect that it could easily compete with other investments which had an initial cost of 10 million yet returned 10% interest per year. Thus a rational price might actually be 10 million dollars per license provided that the revenue from a gun license was reliably stable. So to recap if the price of a license is correlated with fees then as volume on the exchange increases so does the price.

Total fees per trade were expected to never fall below 0.5% (0.25% for security guards). This guarantee was inherent in mechanisms provided by the market creation fee, the validity bond, and the anti-spam measures which would prevent market creators from trying to undercut each other. These mechanisms provided a very real floor below which fees could go no further without an exponentially increasing cost imposed to the market makers. The highest fee that was ever proposed as a trading fee was 2% and the lowest proposed was 0.5%. If fees were able to push downward to 0.1% then it should be 5x more expensive to create such a market but it might not guarantee you 5x more volume. Also since the fee structure was split 50/25/25 for security guards, market creators, and liquidity providers you were going to make 10x less profit not 5x less profit unless you both created and provided liquidity for a market.

Now a security guard’s wage has an entirely different calculation:

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Under the old architecture StockTrader fees might have been directly correlated to the price of REP. One might have expected that an increase in the fees collected would make REP more valuable and thus result in a greater demand for REP which would drive up the price. Under the new architecture StockTrader fees are more complex because they are inversely proportional to the price of REP. This takes some time to understand but in order for StockTrader to be non “rent-seeking” there needs to be this type of inverse relationship. This is very much in line with several statements members of the team have made previously.

What Conclusions Should We Draw From This?

This means that a rising price for a gun license can effectively cut fees. It also means that a falling price for a gun license can effectively increase fees. But either way fees can go much lower than previously expected. Fees are expected to go as low as 0.01%. So a hundred dollar settlement on an open market position is expected to generate a fee of 1 cent. Let’s rejoin Alice and Bob now to see how this changes Alice’s perspective.

Bob: Hey Alice wow I just read an article about StockTrader it seems like they are going to launch soon you must be really excited.

Alice: I already sold my gun license

Bob: What? Why? You were so excited and enthusiastic about this project.

Alice: Not anymore they changed their formula for fees.

Bob: But they haven’t even launched yet. I’m sure as they get closer to launch the price is going to increase.

Alice: Until people realize that there is no fee basis for the price and it crashes yes.

Bob: What do you mean?

Alice: The fees security guards can collect now start off 5x lower than expected and then go to 50x lower. The formula is optimized to pay the security guards the lowest wage possible to secure the exchange.

Bob: But I thought you said that the fees were already significantly lower than any competing platform? If other platforms are unable to compete with the old fees why push the fees even lower?

Alice: The new fees represent something close to the absolute theoretical minimum.

Bob: The theoretical minimum of what exactly?

Alice: The minimum beyond which if fees were to go any lower then traders would be at risk of security guards making wrong decisions for the sake of financial gain. In this new model fees can’t be undercut because they simply can’t go any lower.

Bob: But, if you have drastically lower fees, then the cost of a gun license should go down drastically right? Wouldn’t this result in criminals purchasing cheap gun licenses and then deciding to become traders so that they might make incorrect decisions for financial gain.

Alice: StockTrader’s security model is a bit more complex than that so there are other security backstops which should always protect traders from criminals. Even if criminals have a gun license and work as a security guard on the exchanges this in no way will allow them to take advantage of traders. In fact only 1% of gun license holders are required to be honest to maintain security which is why many of us felt we were no longer needed.

Bob: But what about all those who purchased in the crowdsale. Doesn’t the development team also own gun licenses. Why would they want to devalue their own asset.

Alice: If you don’t plan on selling your gun license for the next three years I am sure that you will eventually be able to exit at a profit. If StockTrader is going to become the absolutely greatest platform for trading with the lowest fees theoretically possible then the price needs to adjust downward by a lot.

Bob: How much is a lot?

Alice: Well the current market cap is 308 million and with 120 licenses that’s about 2.56 million per license. I expect licenses to sell eventually for somewhere between 250,000 and 500,000

Bob: Wow it went up a lot but 250,000 is 10x less than what it is today! Are you really sure about that.

Alice: It went up about 30x but Ethereum went up about 300x and bitcoin went up about 15.5x (if you count the value of both Bitcoin and Bitcoin Cash). Nothing about the price is certain but eventually it’s very likely that the price will go down to 5x to 10x what people paid during the crowdsale.

Bob: Well that is still a good profit over a two year time period but relative to Bitcoin or Ethereum that is a financial loss.

Alice: Yes but most of the crowdsale participants have already left. Less than 33% of the gun licenses now are owned by people who purchased during the crowdsale.

Bob: But if that’s true then that means that there will be a number of people who suffer a financial loss.

Alice: Exactly.

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