How blockchain empowers market design: rules and data
Blockchain Overview
Disclaimer: This article is a final deliverable from Prof. Luyao Zhang’s project entitled “Trust Mechanism Design: Blockchain for Social Good,” supported by the 2022 Summer Research Scholarship (SRS) program at Duke Kunshan University. We give many thanks to DKU 2022 SRS program and SciEcon Insight editorial board.
Highlights:
- Research: The idea of blockchain can be connected with the mechanism design theory in the classic economic field. The development and continuous improvement of the mechanism design theory provide scholars with more scientific and reasonable methods for analyzing, researching, and improving social-economic resource allocation.
- Innovate: As a new type of Internet technology, Blockchain technology has changed the traditional transaction recording process, improved the accuracy of transaction information, realized real-time data recording and transmission, and has gradually become an important part of the audit field.
- Leadership: In a broad sense, blockchain technology is expected to completely reshape the current form of human social activities and bring profound impacts to the disciplines of finance, technology, culture, and politics.
Keywords: #blockchain #, #market design#, #market mechanism#, #automated market maker#, #decentralized technology#
1. Introduction
The implementation of Bitcoin can be traced back to 2008, when Satoshi Nakamoto first introduced the world to it as “a volatile digital currency that is untethered to any specific institution or country” (Ornes, 2019). As the fundamental supporting technology of Bitcoin, blockchain allows digital information to be recorded and distributed, but not edited. In this way, blockchain can be viewed as the foundation for immutable ledgers (Aoyagi & Ito, 2021). All users have access to this distributed ledger and its transaction record. Once a transaction has been recorded in the shared ledger, it cannot be modified.
Blockchain technology is a decentralized peer-to-peer trading system that does not require a trusted authority or central server (Baldwin, 2018). The advantages of blockchain technology lie in its decentralized design by applying timestamps, encryption algorithms, tree diagrams, and consensus algorithms. Figure 1 presents the characteristics of decentralized governance. For instance, consensus algorithms enable the network to validate transactions and protect the information. Also, users can record and secure financial transactions by using a timestamp. Therefore, blockchain successfully solves various problems, including poor reliability, low security, high cost, and low efficiency in the current centralized model (Cong et al., 2021).
Figure 1. Decentralized System
The essence of blockchain is a distributed ledger database that is “transparent, traceable, and difficult to tamper with” (Anjum et al., 2017). Its design generally adopts mature cryptographic algorithms to ensure its security, including communication security, data security, and password security (Härdle et al., 2020). Blockchain technology can enable nodes located in different regions to establish an effective consensus mechanism in a non-trusted environment. In this regard, the “honest” nodes can reach an agreement and provide a traceability basis for the information. Thus, the data and information on the network are credible and reliable. Blockchain technology can effectively deal with various problems caused by the centralized management of traditional databases with their distributed structure. Meanwhile, in terms of data integrity protection and reliability improvement, the emergence of blockchain technology can bring better solutions to data transmission and storage.
Recent years have witnessed a sharp increase in the popularity of blockchain technology. Both public and private entities are implementing numerous blockchain projects. With the rapid development of Bitcoin in recent years, the blockchain has attracted much attention from both academia and industry due to its unique advantages. It contributes to multiple fields, such as electronic voting platforms, contract management, and supply chain auditing (Benetton et al., 2021). As a new type of Internet technology, Blockchain technology has changed the traditional transaction recording process, improved the accuracy of transaction information, realized real-time data recording and transmission, and has gradually become an important part of the audit field (Garanina et al., 2021). In the future, real-time auditing, comprehensive auditing, intelligent auditing, and algorithmic auditing will gradually occur. Blockchain is regarded as a milestone computing paradigm with great potential to spark a significant revolution. In a broad sense, blockchain technology is expected to completely reshape the current form of human social activities and bring profound impacts to the disciplines of finance, technology, culture, and politics.
1.1. Major Blockchain Categorization
As blockchain is still in its nascent stages, there has been controversy regarding the divisions in blockchain technology. Blockchains can be categorized as permissioned and permissionless blockchains, based on whether an approval process is required when participating in a certain role (Lehar & Parlour, 2021).
Table 1. Blockchain Categories
Permissioned blockchains are private blockchains. They are closed ecosystems that can only be accessed by permission. The so-called “private” refers to the system only used within the organization and not open in terms of access to other parties, such as enterprise bill management, accounting, auditing, supply chain management, etc., or some government management systems. Anyone who intends to validate transactions or view data on the network needs to get approval from a central authority (Kello & Sluganovic, 2017). In the process of using the private chain, there are generally registration requirements. This type of blockchain can be applied to companies, banks, and institutions that are comfortable complying with the regulations and are very concerned about having complete control of their data. Ripple is an example of a permissioned blockchain.
Permissionless blockchains are known as public blockchains, which allow anyone to transact and join as a validator without a central authority to own or control the network. The permissionless blockchain model is open-source, and a software program is required for participants to join the network. Data on these blockchains are publicly available. One can remain relatively anonymous since there is no need to identify themselves to perform transactions (Bakos & Halaburda, 2021). Once a transaction is validated, the data will be recorded and immutable. While there is no third party in the public chain system, the system relies on a set of pre-agreed rules to ensure that each participant can initiate reliable transactions in an untrusted network environment. Popular public blockchains such as Bitcoin, Ethereum, Litecoin, Dash, and Monero fall under this category (Buterin, 2013; Namecoin Whitepaper, 2018).
Table 2. Major Blockchain CategoriesTable 2. Major Blockchain Categories
2. The Market Mechanism/Design in Classic Economic Literature
The idea of blockchain can be connected with the mechanism design theory in the classic economic field. The development and continuous improvement of the mechanism design theory provide scholars with more scientific and reasonable methods for analyzing, researching, and improving social-economic resource allocation (Whitaker & Kräussl, 2020). Considered a complete theoretical system for economic mechanism study, mechanism design theory has been widely applied to various fields (Conitzer, 2010). The theory of economic mechanism design refers to creating a system for a given economic or social objective. The key idea is to identify goals first and then construct a system that achieves these goals. This theory can answer whether or how to design an economic mechanism in decentralized decision-making situations such as individual rationality (Füllbrunn, 2009). Thus, the individual interests and mechanisms of participants in economic activities will follow the goals established by designers (Shi et al., 2021).
Mechanism design theory was proposed by Leonid Hurwicz, a professor of economics at the University of Minnesota, USA. Hurwicz believes that the economic environment and social system are constantly changing. Therefore, the economic mechanism should be an endogenous variable rather than an exogenous variable of economic operation. According to Hurwicz, a mechanism is a communication system where participants exchange messages and jointly determine the outcome (Wilson, 1977). Based on this finding, Hurwicz establishes a framework for comparative analysis of institutions and uses this framework to compare market mechanisms to achieve the effective allocation of resources. Later, Hurwicz puts forward the concept of incentive compatibility (Wilson, 1967), which means that when any rational economic person pursues the goal of maximizing personal interests, they can also achieve exactly what the designer expects to be achieved. The concept of incentive compatibility is applied to mechanism design, successfully solving the problem of incentives for participants in economic activities. Moreover, it establishes the analytical framework of mechanism design theory.
Figure 2. Mechanism Design in Economics
Auction design is a popular topic in economic research (Füllbrunn & Sadrieh, 2012; Roth & Ockenfels, 2002; Shih et al., 2021; Balseiro et al., 2021). Auctions are a common and traditional form of transaction for selling goods that are not easily valued. It is an ancient trading method widely used in the sale or purchase of various items. Modern auction theory began with the pioneering work of William Vickrey (Vickrey, 1961). Vickrey mainly studies single-item auctions with private value. In this type of auction, the seller has an indivisible item to sell that may have different values to different buyers, and these values are independent of each other. In auction transactions, there exists serious information asymmetry between sellers and buyers. Generally, buyers have a strong incentive to bargain. However, since sellers lack important information on buyers’ valuation, such a transaction method cannot guarantee the efficient allocation of scarce resources. In any given transaction, it cannot be guaranteed that the item is the most valuable to this buyer.
Since Vickrey first introduced the modern game theory tool in his paper, auctions have entered the field of economics (Vickrey, 1961). Vickrey established the standard for auction research based on the private value assumption. With additional researchers, auction research has been extended from single-item auctions to multiple-item auctions. It was Wilson and Milgrom who carried the auction study forward. Wilson proposed a pure common value model, while Milgrom put forward a hybrid value auction model (hybrid value), which comprehensively studied private value and common value. The mechanism of the multi-item auction has been creatively designed (Feng et al., 2017). As noted by the Nobel Prize Committee, Wilson and Milgrom’s research deepens and broadens the analytical foundations of the auction field. Their research answers how bidders bid within different auction formats and provide fruitful solutions to extremely important practical problems, such as designing auctions to maximize social value.
In today’s economy, auctions are more widely used than ever (Herweg & Schmidt, 2017; Deng et al., 2021; Fowler & Pirker, 2021; Kireyev, 2020), with transaction subjects ranging from corporations to governments, and auction items ranging from antiques, private consumer goods, public resources, and public assets. With the development of e-commerce, the transaction volume of items relying on Internet platforms and through Internet auctions has grown rapidly. Even Internet platforms choose to sell their online advertisements through auctions, setting off a wave of tech companies hiring economists who play a pivotal role in the market design and incentive mechanism design of Internet platforms. This development contributes to the rise of research in auction market design.
Like auction market designers, game theorists also focus on the impact of the rules of the game on the participants’ behavior (Ockenfels & Roth, 2001). However, mechanism design theory is different from game theory. It does not study the process of people’s game behavior. Instead, it can be viewed as an improvement and extension of general equilibrium theory, emphasizing the optimal economic activity and the choice of mechanism (Dütting et al., 2021).
Mechanism design “has broad applications, from economics and politics (markets, auctions, voting procedures) to network systems (inter-domain internet routing, sponsored search auctions).” At present, China is in a critical historical period of comprehensively deepening the market-oriented reform and expanding the opening up. Hurwicz’s economic theory innovation is of great practical significance to the innovation and development of economics in China. Moreover, the mechanism design needs to consider the decentralized peer-to-peer or distributed system.
3. Summary of Literature on Blockchain Market Type
In the current situation of unprecedented changes such as the COVID-19 pandemic, traditional market economic theory and pure government intervention theory cannot explain or solve the dilemma people face. Therefore, it is necessary to seek a theoretical construction and policy exploration that combines the government and the market. Aiming to combine blockchain technology with the market, it is essential to study the blockchain market types. Various blockchain market types include auctions, decentralized exchange-order books, decentralized automated market makers, and flash loans (decentralized finance marketplaces).
3.1. Auction
In the auction mechanism, the social welfare of the blockchain network is maximized. Meanwhile, individual rationality and computational efficiency can be guaranteed (Jiao et al., 2018). Jiao et al. (2019) propose auction mechanisms that maximize the social welfare of the blockchain network and further provide effective strategies for the cloud computing service provider. A study has developed an iterative auction mechanism aiming to maximize the profit for consumers and suppliers (Hassija et al. 2019). Under such a mechanism, a smart contract serves as an auctioneer to maximize overall profit. Once both the seller and buyer are satisfied, the smart contract will create a block that both parties can digitally sign (Häfner & Stewart, 2021). Moreover, the privacy of users is well protected. Such a fully decentralized mechanism eliminates privacy and security issues and successfully cuts down broker fees.
One of the most prominent DeFi (decentralized finance) innovations is decentralized exchanges (Capponi & JIA, 2021). In the traditional format, exchanges refer to situations where buyers and sellers of a commodity agree on a specific price based on demand and supply. In these situations, the exchange can be regarded as a common marketplace. Over time, it has developed into an organized marketplace regulated by rules. Decentralized exchanges (DEXs) are peer-to-peer marketplaces. By using self-executing agreements written in code, cryptocurrency traders facilitate transactions directly without handing over the management of their funds to an intermediary called smart contracts. Decentralized exchange can facilitate exchange functions without relying on a central authority. Analyzing a decentralized exchange-order book matching algorithm is important because this will largely affect the algorithm’s ease of use, ability to provide fair exchange rates, and users’ waiting time (Parlour, 2021). Decentralized Exchanges also enable users to create markets for exchanging any pair of cryptocurrencies. Previous research indicates that traders can utilize smart contracts to mitigate users’ financial loss (Wang et al., 2021).
Figure 3. Auction and Smart Contract
3.2. Decentralized Exchange-Order Book
An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs) (Sergeenkov, 2021). The exchange-automated market maker allows traders to exchange one crypto asset for another automatically on a blockchain. Ongoing evolutions in decentralized finance (DeFi) have led to a rapid increase in the use of AMMs for creating DEXs (Mohan, 2022). While DEX arbitrage and trade routing among similar AMMs can be performed efficiently on-chain within smart contracts, this motivated researchers to create a new AMM design called Automated Arbitrage Market Maker (A2MM). A2MM aims to unite multiple AMMs to reduce overheads and costs, increasing blockchain security. It serves as a decentralized design for users to collect MEV, mitigating the dangers of centralized MEV relay services (Zhou et al., 2021).
Flash loans are a recent blockchain smart contract that enables the issuance of loans that are only valid within one transaction and must be repaid by the end of the transaction. It consists of a specific form of contract in which the loan is taken and repaid simultaneously. A previous study indicates that flash loans are beneficial when performing arbitrage in a globalized crypto market (Caldarelli & Ellul, 2021). However, while providing convenience, flash loans also enable attackers to launch malicious operations and steal assets that they do not have. Based on this issue, research explains how adversaries can maximize attack profit and hence damage the DeFi ecosystem (Qin et al. 2020). By designing a different mechanism to identify flash loan transactions, flash loan services have become more popular over time.
Table 3. Market Type and Examples
Besides market design, the financial sector is one of the most popular topics in blockchain technology applications. Blockchain technology has been applied to the financial industry for a wide range of experimental applications and exploration. It has aroused much attention from multiple financial giants, including Citibank, JP Morgan Chase, Goldman Sachs, Bank of New York Mellon, HSBC, Barclays, and many other financial giants. The McKinsey research report pointed out several major blockchain applications in the financial industry (Blockchain beyond the hype: What is the strategic business value? 2018). For instance, digital currency can enhance the convenience of currency issuance. Moreover, cross-border payment and settlement can achieve point-to-point transactions and reduce costs. The Australian Stock Exchange believes that the distributed general ledger technology can significantly simplify and accelerate the post-transaction processes, reduce risk, decrease management and compliance expenditures, and allow investors to access almost real-time settlement and securities trading speed (Milani et al., 2016). Insurance institutions are responsible for fund collection, investment, and claims, often with high management and operating costs. However, through the application of smart contracts, neither the policyholder’s application nor the insurance company’s approval is required (Ismail & Zeadally, 2021). It allows people to register for customized micro-insurance products through the chat function of Facebook. Recently, Nasdaq Private Equity Market launched a blockchain-based financial service platform called Linq. As a complement to its private equity trading platform, Linq expands and enhances its stock management capabilities (Zhu & Zhou, 2016). As a global banking network, Citibank is also exploring ways to use blockchain technology for cross-border flows of funds across their banking networks, which will help simplify cross-border transfers and reduce transfer costs (QIAN and SHEN 2016).
The application of blockchain technology in the financial industry can eliminate the need for third-party intermediaries. The payment and transfer behavior of digital currency (such as Bitcoin) is supported by blockchain and can be used for various payment scenarios (Wu & Liang, 2017). The world’s leading financial institutions seek to explore the blockchain of landing applications. UBS is studying blockchain-based “utility settlement coins” to solve settlement efficiency. Visa launched Visa B2B Connect (Arnfield, 2019). This application allows institutions to process international business-to-business transactions with a more secure cross-border payment approach. Compared with the traditional cross-border payment system that needs to wait 3–5 days and pay a transaction fee of 1–3%, Visa B2B Connect is faster with a lower cost. Visa also launched the first Bitcoin debit card, and Citibank tested the cryptocurrency “Citicoin” on the blockchain.
4. Datasets of the Blockchain Markets for further analysis of Applications on the blockchain
4.1 Datasets in Existing Academic literature
As a new type of Internet technology, Blockchain technology has changed the traditional transaction recording process, improved the accuracy of transaction information, realized real-time data recording and transmission, and has gradually become an important part of academic research. Therefore, data is always connected with scientific methods in blockchain research. For example, from the conventional theoretical modeling perspective, Carvalho (2021) applies decision theory and explains how loot boxes can be coded as smart contracts running on a blockchain network. He further illustrates why this solution effectively tackles the transparency and trust problems. Memon et al. (2019) present the modeling of blockchain-based cryptocurrencies by implementing simulation methods. Through running simulations for two months of transactions, they validate the model using the data from Bitcoin and Ethereum. The data sources of blockchain cryptocurrency transaction network analysis mainly include blockchain transaction data and tag data. The most primitive way to obtain blockchain transaction data is to access the blockchain network and synchronize block data to obtain the original data of the blockchain. When a transaction is recorded in the blockchain, details of the transaction such as price, asset, and ownership, are recorded, verified, and settled within seconds across all nodes. A verified change registered on any ledger is also simultaneously registered on all other copies of the ledger. Tag data allows users to organize information more efficiently by associating pieces of information with tags or keywords (Hardjono et al., 2019).
Other datasets aim to organize and contextualize information for crypto professionals, such as Messari. Mahdavi-Damghani et al. (2021) discuss the historical events that have led to the rise of cryptocurrencies by utilizing the data gathered from web-scraping, the Messari database. Coinmetrics organizes the world’s crypto data and makes it transparent and accessible. Based on behavioral economics, Aloosh & Ouzan (2019) analyze the dynamic of cryptocurrency prices by applying the data from Coinmetrics. Fenu et al. (2018) study the factors that most likely influence the ICO success likeliness. By deriving data from Alpha Vantage API, Patil et al. (2018) conduct a comparative study and determine the value of cryptocurrency in the future.
Table 4. Data Source and Current Research
For some blockchain systems that enable smart contract functions, their internal transaction records are not stored in the blockchain system.
4.2 Further analysis for Applications on the blockchain
Based on existing information, there are many other data sources that are worth researching that current literature fails to study. The Bitcoin blockchain system was the first successful application of blockchain technology. It has been running for more than eight years, fully demonstrating its strong stability and security. In recent years, the blockchain has been deeply integrated with different fields, including finance, agriculture, energy, public welfare, medical care, etc. (Javaid et al., 2021). Nowadays, blockchain technology has undoubtedly become one of the most popular technologies. Most of its applications focus on the financial field, such as digital currency, cross-border payment, securities trading, property registration, certification, and so forth. However, most blockchain applications are still in the preliminary and experimental stages. According to previous research, security incidents frequently occur (Fedorov et al., 2018), which brings a lot of economic losses to users and blockchain service providers. What makes the situation more complicated is that once the blockchain smart contract is deployed in a distributed and decentralized network, it will be extremely difficult to modify it. On the one hand, this prevents data manipulation and establishes a reliable mechanism. On the other hand, when faced with security attacks, this feature hinders the blockchain system from establishing an effective correction mechanism, making it difficult to recover losses timely.
Whether these current issues can be solved largely depends on further study on the blockchain. Several datasets of the blockchain market provide opportunities for further analysis. For instance, DeFi Pulse Data brings together API Endpoints that provide critical Ethereum and DeFi data that help developers, students, entrepreneurs, researchers, and applications understand the decentralized ecosystem (“DeFi Pulse — the Decentralized Finance Leaderboard | Stats, Charts and Guides | DeFi Pulse,” n.d.). While the DeFi optimists agree that DeFi may have the great potential to build a permissionless and noncustodial financial system, the pessimists believe that there are many challenges of DeFi, such as economic and technical security issues (Werner et al., 2021). Nevertheless, different DeFi optimist and DeFi pessimist views make DeFi a worthwhile and promising area for future research. Another Web UI App is called OpenBiSea NFT marketplace, a smart contract, iOS, Android, and web UI app. It provides a simple, step-by-step guided solution to buy, sell and make auctions for NFT. The main core smart contracts are built on the Binance Smart Chain, polygon, and have an Ethereum bridge for NFT assets. However, NFT’s innovation must be paired with education before its community can further expand and grow beyond its current borders.
The third example, Compound Finance, is a marketplace used by crypto investors to lend and borrow their digital assets. It is especially important since The compound is an algorithmic, autonomous interest rate protocol built for developers to unlock a universe of open financial applications (“Compound,” n.d.). Compound crypto is a decentralized protocol, or dApp, built on a blockchain (“NFT Market & Auction). Similar to Compound Finance, Uniswap is a cryptocurrency exchange that uses a decentralized network protocol (“Home | Uniswap Protocol,” n.d.). It is proved to be stable under various market conditions (Popescu, 2020). As a secure online platform for buying, selling, transferring, and storing cryptocurrency (“Coinbase — Buy & Sell Bitcoin, Ethereum, and More with Trust,” n.d.), Coinbase can be applied to investigate the investors’ mood and their investment decision (Angeris et al., 2021). The last example is a P2P crypto-products trading platform (“Perpetual Contracts Guide — BitMEX,” n.d.) called BitMEX. Its derivatives have positive net spillover effects, are more efficient than bitcoin spot prices. The study demonstrates that regulators prioritize the investigation of the legitimacy of BitMEX and its contracts (Alexander et al., 2019).
Table 5. Data Source and Related Market
As an emerging technology, blockchain applies decentralized technology settings to multiple fields and solves many practical problems. However, it also gives rise to new problems. Under such circumstances, if laws are regulated at every turn, the development and application of blockchain technology are likely to be negatively affected. Most countries are open to blockchain technology, expressing that they should adopt a tolerant attitude towards applying blockchain technology in related fields.
The U.S. House of Representatives has held several meetings on the development of blockchain technology (Catalini & Massari, 2021). After in-depth discussions, the House of Representatives issued a non-binding resolution related to blockchain technology to encourage new technologies to protect consumer rights. Blockchain technology conducts direct supervision but strengthens the supervision of digital currency. China also believes that the application prospect of blockchain in the financial field is very promising, and it is determined to promote the application process of blockchain technology. In 2016, the China Internet Finance Association formally established a blockchain research working group, which is mainly responsible for in-depth research on the application and impact of blockchain technology in the financial field, pays close attention to financial risks and regulatory issues, and conducts research on regulatory issues such as risk management of blockchain applications in the financial field.
At present, the blockchain industry is developing rapidly. In the future, we should make joint efforts to achieve breakthroughs in the blockchain field. While encouraging the development of blockchain technology, applications, and markets, the government should implement the appropriate guidance for blockchain applications and regulate them. Moreover, increasing investment in blockchain technology research will also be essential and beneficial in the long run.
About the Author
Zhitong Chen is a researcher at SciEcon CIC and a senior majoring in economics at Duke Kunshan University. She is the 2021 National Scholarship recipient and the 2020 National Endeavor Scholarship recipient. As an interdisciplinary researcher with passion and research experiences in applied economics, finance, blockchain, political economy, and education, Zhitong received Research Grant from the Center for the Study of Contemporary China. She also received Student Experiential Learning Fellowship and Summer Research Scholar Fellowship yearly. Her paper was accepted for the International Conference on Blockchain, Information Technology, and Smart Finance. Pursuing her ambition, Zhitong interned at China International Capital Corporation Limited, China Securities, Ernst & Young Global Limited, CITIC Securities Company Limited, and China Merchants Bank. She is actively involved in different social activities and volunteer work. Zhitong is nominated as one of the 30 finalists for the 2021 Miss World Tourism and Culture Competition.
Acknowledgments
Associate Editor: Xinyu Tian
Chief Editor: Prof. Luyao Zhang