Two Classic Cases in Networks Vs Hierarchy; Exchanges and Bitcoin

What do commodity exchanges have in common with Bitcoin?  Most people would think not a lot.  But, the fact is they do.  For example, clearinghouses are a closed private blockchain.  I was thinking about this in terms of a post that I put up recently that struck a nerve.

A lot of people blame the tone deafness of exchanges because they changed from member run to demutualized publicly traded companies.  No doubt, changing the structure changed some of the incentives.  As a person who advocated for demutualization, I put my trust in the people that would lead exchanges. I thought they would view and treat the market the same way members had for over 100 years.  They do and they don’t.

On the other hand, if exchanges didn’t demutualize, they’d be out of business today.  In 1994, a full seat at the CME traded close to $1M.  That’s how advantageous being on the floor was back then.  In four short years, you could have picked one up for under $300K.

Here is an important concept to consider.  When exchanges were member run and open outcry, they had nodes on a network that operated the exchange.  Individuals that were out for their own best interest managed individual pits by committee.  There was a centralized hierarchy, but it was member run.

To be clear, there were over 200 standing committees that made the exchange a highly bureaucratic place.  That needed to end and the way to solve for it, along with monetizing the assets of the members was demutualize.

Upon demutualization, exchanges rapidly changed from nodes on a network to centralized hierarchical bureaucracies.  They became tone deaf to market participants.  The corporate employees also didn’t understand the economic incentives of the market participants and so they made decisions that might not have been in the best interest of the market-but it was the in the best interest of the centralized bureaucracy.

The Bitcoin community right now is in the midst of a tremendous debate.  It is more complex than the debate that happened at the exchanges in the mid 1990’s.  One reason it’s more complex is that many of the people engaged in the debate are behind the firewall in China.  They have different pressures, cultures and economic incentives than people on the other side of that firewall.  There is a raging debate over block size, and the outcome will determine some winners and losers.  My friend William Mougayer has been investigating this debate.  You can learn more about the entire Bitcoin ecosystem here.

Yesterday, Dash announced that is was doubling the size of the blocks it would clear from 1MB to 2MB.  Dash is the number three cryptocurrency in the world – behind Bitcoin and Litecoin. It currently hovers around $4 per coin and has a $25 million market cap (similar to bitcoin in 2011) vs bitcoin’s market cap of nearly $6 billion. Dash now has a robust international user base, including more nodes than bitcoin itself. The cryptocurrency is also completely decentralized.

But, the real crux of this debate is over centralized versus decentralized governance-just like exchanges.  I believe going one way or the other is the wrong choice-and forcing that choice is a false dichotomy of choice.

The very interesting thing to me about Bitcoin is that it is totally decentralized.  Decentralized networks don’t have a streamlined way of making decisions.  They are a market-and markets often are messy as they go through the decision making process.  But, markets are better at allocating resources than centralized bureaucracy.  They also make better decisions for the long run given time.

In the case of Bitcoin, the centralized group ought to agree on a long term vision.  It should not be hard and fast metrics, but basic core principles.  The community should come to a consensus on how to get there.  In achieving that consensus, certain principals of the community will be hurt.  There will be winners and losers.

The Bitcoin community should take a cue from the mistakes commodity exchanges made.

  • KIR

    As an advocate of decentralization in all industries, I do not think the term applies to what the CME did. Their argument was that it was unfair for a handful of men to have access to customer orders. It needed to be open to anyone who had the internet. Unfortunately, an internet connection doesn’t get you a seat at the table. Instead of a hundred guys fighting each other to get on an order, there is one computer program that sees the order before the rest of the trading public. Competition moving from 100 people who are blessed by their connection and geography to 1 HFT firm who is blessed by its connectivity and collocation is the exact opposite of decentralization. It’s Crony Capitalism. Further, the value of a seat was diluted because people could now trade all markets at once, rather than a single pit.

    • No this is incorrect. The fact is we demutualized. Part of the demutualization we turned the management of all facets of the exchange over to corporate employees with oversight from a corporate board. Pre-demutualization, members over saw everything using a bureaucratic committee system.

      Neither exchange would have survived if it didn’t demutualize.

      Boards are there to support and mentor management teams, not be destructive. It’s rare when a board takes action to remove a CEO.

      There wasn’t a master plan of colocation etc, but the business evolved that way because of the different economic incentives corporate employees have versus individual members.

      The value of a seat is diminished due to co-lo, and it’s effect on industry consolidation. The value of a seat is further diminished by laws like Dodd-Frank; which took a high margin low capital business and turned it into a low margin high capital business and tremendous consolidation in the FCM market. Of course, FCMs merged and were rolled up because of harsh regulation which exponentially ramped up operating costs, combined with a smaller pool of traders to service which was caused by the way electronic trading was structured.