Intermediaries - Making or Breaking the (Stablecoin) Market

by Nadiem Sissouno, Head of Economics at Mento Labs, during StableSummit in Paris, July 2023

Nadiem explores the crucial, yet often underestimated, function of intermediaries in shaping network architecture, market efficiency, and the overall adoption of stablecoins. He assesses the pros and cons of existing distribution models and underscores the pivotal role of intermediaries in fostering trust. Blockchain is all about trust, and intermediaries are pivotal in establishing trust within the financial system and the market. So, why consider replacing them? Nadiem seeks answers to what alternatives should be contemplated.

Part 1:

Introduction

Today, I want to touch on a mantra that is very essential to blockchain technology, one that advocates for the removal of intermediaries to enable direct peer-to-peer transactions. Let us have a look at intermediaries in the space of stablecoins. Picture a stablecoin issuer on one end, and a consumer on the other. Between them, various intermediaries facilitate transactions. Among these, brokers or over-the-counter (OTC) desks, market makers, and ramp providers play pivotal roles. Consumers typically engage directly with brokers and ramp providers, while their interaction with market makers is indirect, often mediated through a retailer, such as a centralized exchange or decentralized exchange (DEX).

Making the Market

While intermediaries often face criticism, it's essential to recognize the valuable role they play in the ecosystem. Take market makers, for instance. Their function can be likened to that of wholesalers in traditional markets. Beyond providing liquidity, market makers play a pivotal role in narrowing bid-ask spreads and absorbing imbalances in the market. They continuously adjust liquidity in response to anticipated selling or buying pressures, ultimately contributing to price stabilization. This function is particularly critical in the crypto sphere, where thin order books can lead to erratic price movements in the absence of active market maker participation. Turning to brokers and OTC desks, they occupy a hybrid role, functioning as both wholesalers and retailers. Often, they facilitate trades in less liquid markets. For instance, if a partner wishes to trade a token but lacks direct access, they typically engage a broker or OTC desk for assistance. While these entities provide a crucial convenience service, their role is perceived as less critical compared to that of market makers, whose actions directly impact price stability and market liquidity. Moving on to ramp providers, they primarily function as retailers, specializing in crypto-fiat conversion services akin to those offered by centralized exchanges. However, centralized exchanges offer additional functionalities such as facilitating fiat transfers, price matching/making for fiat currencies, and providing KYC services. On the other hand, decentralized exchanges are limited to offering crypto-to-crypto prices. Given the significance of fiat prices in the contemporary financial landscape, there is a pressing need for entities like ramp providers to establish fiat prices for assets in the crypto space. As a last market actor I would like to highlight arbitrageurs, even though they are not intermediaries in the sense of the other four. Arbitrageurs play a crucial role in ensuring price consistency across various trading platforms. Unlike traditional intermediaries, arbitrageurs capitalize on price discrepancies between markets to facilitate the efficient allocation of assets. By exploiting these differences, they seek to converge prices towards a single equilibrium, thereby minimizing global market inefficiencies. This process can be likened to a consensus mechanism, where arbitrageurs collectively strive to establish a consensus on asset prices. However, unlike conventional consensus mechanisms found in blockchain technology, arbitrage operates as a continuous and fluid mechanism, where constant buying and selling shape market equilibrium.

Market efficiency is crucial; it describes a state where the following key market conditions prevail:

• Proximity of buy and sell prices
• Price convergence across different marketplaces
• Price independence from the traded amount
• Availability

Proximity of buy and sell prices means that the prices at which you can buy and sell an item are close to each other. If there's a big difference (called spread) between the buy and sell price, users or traders hesitate to make transactions because they'll incur a loss with each transaction due to the wide gap between prices. Tighter spreads between buy and sell prices encourage more transactions and promote market activity. Price convergence across different marketplaces is essential. Just imagine living on a street where one grocery store is selling the same bar butter for five euros and another for two. You'd likely buy from the cheaper store, but the discrepancy would unsettle you. Similarly, independence from the traded amount is crucial; you don't want massive slippage when buying larger quantities. Availability is also key; you want convenient access to your goods. All of those are particularly important and even more noticeable for stablecoins that are meant as a medium of transfer and transaction, discrepancies across these four conditions will inhibit utility.

Intermediaries emerge as a way to mitigate market inefficiencies. Most of their functions directly relate to at least one key market condition of market efficiency, and if executed faithfully, increase and secure market efficiency. Intermediaries are facilitators of efficient markets that can be trusted for being fair, transparent, reliable, and accessible. Blockchain is all about trust, and intermediaries play a vital role in creating trust in the financial system and the market.

Breaking the Market

So, why do we want to remove them? There are also good reasons for that. The first thing is, to perform their services, intermediaries are granted significant privileges. For example, if you look at the example of Tether or Circle, intermediaries in this setup have the right to issue and redeem, which is a significant privilege. If you are a standard user, you are not able to redeem your coins directly, but you have to rely on secondary markets and the market makers that are maintaining them. If you want to redeem your coin in case of a price drop, you will not be able to because you have to go to the market and pay the market price. Only institutional entities will be able to use the redemption facility and redeem one-to-one. So, this is really important for stablecoin projects that basically want to offer redemption and issuance at the promised price. There are many more examples of these privileges, and because of these privileges, if intermediaries are misbehaving, the effect is massive. This is what basically causes all the resentment that we have towards intermediaries. The distrust comes from a history of intermediaries abusing their privileges.

Intermediaries play a dual role in our financial systems. On one side, they are pivotal, providing essential services and facilitating the smooth functioning of markets. However, on the flip side, they also pose risks and vulnerabilities, as evidenced by past incidents. So, how do traditional markets address these challenges and mitigate the associated risks?

In traditional markets, we introduce two essential components to address these challenges by establishing robust legal frameworks and regulations. These frameworks essentially form contractual agreements between issuers and intermediaries, with the aim of committing intermediaries. Through regulation, we create a structured framework that binds these centralized intermediaries, enhancing transparency, oversight, and accountability. In essence, regulation acts as a form of embedding, reinforcing the safety and reliability of intermediaries to safeguard the interests of consumers. It is a positive perspective on regulation, envisioning it as a protective layer that enhances the integrity and stability of the financial ecosystem.

Distribution Models

Now, let’s shift gears slightly. While we've been discussing intermediaries, the concept of intermediation is closely intertwined with another aspect: the distribution of goods. In traditional business models, distributing goods to customers involves two primary methods: external distribution and direct distribution. External distribution relies on intermediaries to deliver goods to users, whereas direct distribution allows users to access goods without intermediary involvement. In the context of stablecoins, external distribution involves relying on intermediaries to facilitate their circulation. Conversely, direct distribution entails a system where users can access stablecoins without intermediary intervention.

Interestingly, if we examine existing stablecoins, we'll notice that the most successful ones typically utilize external distribution models. Let's delve into the reasons behind this in the second part of the post.