A non-technical explanation of Fragmynt's Market Protocol.
The Fragmynt market protocol is a reimagination of how exchanges and markets for single assets should operate (an example of a single asset market is the stock market). It allows fully decentralized and independent markets on anything, solves the constant liquidity issues that plague early markets, provides mechanisms for capital raising and provision of returns similar to dividends, removes problems with frontrunning and other bad actors, and we believe is fairer and more equitable than any modern single-asset market in centralized or decentralized finance. Significantly, all market middlemen are also removed resulting in a cheaper and more capital efficient system.
It is quite simple to state exactly how the protocol operates, but it's a bit abstract. Instead, it's better to walk through how the protocol was designed & the decisions made along the way. By the end of this article you will see how powerful it can be when you make these markets decentralized.
Before we start, we should mention the acronym FEN which stands for Fragmynt Exchange Network. The Fragmynt Exchange Network is the name of the infrastructure that runs the markets and all other systems in the ecosystem. Even though it has Fragmynt's name, it is independent of Fragmynt and is owned by all the people that hold the MYNT token.
All markets in the world are built from the same two parameters:
- Price: i.e. how much does the thing cost?
- Liquidity: i.e. how much of the thing can I buy at a particular price?
You can draw every possible market on the two axes above. The red line shows the shape of an example market. Each point on the red line tells you how much of the asset in the market you can purchase at that price before you change the price. The higher the line, the more you can buy.
What differentiates each market is the shape of the line (the liquidity distribution) and the area underneath it (the market capitalization) in the above picture. We can call this red line the "pricing-function" for the market.
As mentioned, it is the shape of the pricing-function that differentiates markets from one another. In the end, the simple answer to the above question is that everybody in the market decides the shape of the function. They do this by taking actions in the market. In fact, the shape changes and morphs constantly with the actions of each participant.
The most simple action that someone can do is "take a position" in a market. In particular markets this might mean buying or selling a physical thing or investment contract, e.g. a share of a company, but there is a more general way of looking at this as "going long" or "going short":
The difference between "going long" and "going short" involves deciding an answer to the question:
"Do I think the price for the asset will rise above or fall below the current price at some point in the future?"
If you think it will rise you buy into the market and "go long". If you think it will fall you trade against the market and "go short" by closing your position or short selling. The collective trades of every trader participating in the market then creates the shape of the pricing function. The second component of this is how "much" you go long or short (i.e. the amount of money), and this is related to order size.
Order size is basically about how much money you use to go long or short. For a rational participant, you can think of this as being related to how much confidence they have in their decision and where they think the price will end up. There is a limited amount of the market's liquidity that you can buy at each price point. If you buy more than that you will start to push the price higher and have to pay more. Rationally, you should not be paying more than what you think the asset is worth.
These two questions, "long or short?" and "by how much?" form the basis of every market in existence. The two things combined together form the concept of market capitalization, which is a summary of both.
Every time you go long or short in a market you are making a statement about what you think the market capitalization (the total value of the asset) is for that asset. This is easiest to understand in markets involving shares.
What is a share?
A share is basically just a piece of a whole. For example if I cut up an apple into 8 pieces you could say that I have 8 shares of apple. Likewise, if we take the company Apple, its ownership is split up into many equal pieces, also called shares.
For example, there are 16.19 billion shares of Apple. If you purchase one share of Apple for $100, this is equivalent to saying that you think the whole company of Apple is worth 16.19 billion * $100 = $1.6 trillion. If someone after you purchases a share of apple for $150 dollars, this is them saying that the whole company is worth $2.4285 trillion.
The question is: "which of you is right?". The answer is of course both of you, because things are only worth what people are willing to pay for them. The best answer for how much something is worth is to take the average of everybody's answer to that question. And that's of course exactly how markets work.
So how do we get from nothing to that red line? In many modern markets the concept of an order book is used. This means that orders from many individual buyers and sellers are aggregated together. Your pricing function for an order-book based market might look something like this:
It gets its blocky shape because people are buying and selling a discrete thing. There are only so many shares and you can either buy a share or sell a share. The concept of buying half of one doesn't really exist.
The issue with this setup is that it's limited arbitrarily by the fact that the thing you are buying is discrete, and typically concerned with ownership over the asset in question. In order for you to buy Apple shares you need to find someone that is willing to sell them to you. This system is flawed because it places the value of ownership over the value of speculation. However, the truth is that the benefits of ownership in modern asset markets only represents a very small portion of the reason that most people use them. For example, voting rights for companies are rarely exercised by non-institutional investors, and the 10-year average dividend for the S&P500 is only ~2%. Also, the average time to hold a share before selling it is now 5.5 months as of June 2020, down from a period of 8 years in the 1960s. Click here to read more.
No value creation happens on secondary markets. Money simply changes hands between investors back and forth. This is not to say that stock markets and other asset markets aren't important. They are a huge source of information about the health of an economy, the sentiment of people towards the assets themselves, and are essential for the corresponding primary market to work. However, once we are clear on what is happening, we can invent a new market paradigm that comes with numerous advantages.
What are primary and secondary markets?
The primary market is where investors give money directly to the company in exchange for shares. The secondary market is where these shares are then traded back and forth between traders without the company's involvement.
Now we have all the pieces in place to understand Fragmynt's Market protocol. The key design considerations were the following:
- The markets should be accessible to everyone on the planet. The current infrastructure is heavily biased towards giving access to Western nations.
- The markets should be highly capital efficient. Having loads of intermediaries means wasted capital and high fees.
- The markets should be owned and controlled by investors.
- These decentralized markets should be independent of other markets on the same assets. By this we mean that we don't want to use price data from centralized exchanges where these assets may already be traded, we want to create markets where the traders set their own price.
- Traders should always be able to take a position in the market, regardless of the number of people that are trading.
- The market mechanics should be as close as possible to existing centralized exchanges to minimize divergence and encourage information sharing.
- A dividend-like yield that beats ~2% should be provided to make these markets as, or more, attractive than existing centralized exchanges.
The underlying design of the protocol to meet these requirements is complex, but its operation can be stated quite simply:
- Each trade consists of choosing a market capitalization to trade at, whether you would like to go long or short, and the amount of money you want to use.
- Virtual liquidity is distributed in the market according to the market cap you choose and the amount you went long or short.
- The liquidity distribution (and market cap overall) are maintained as an exponential time-weighted average across all investors. This just means that the more recent a trade is, the more it matters.
- Trading fees can be repackaged to periodically provide a dividend-like yield to long position holders in the market.
Let's go through this in more detail in the next section.
We can now describe the market protocol very simply. The technical term for the core piece is an "Automated Market Maker".
What is a market maker?
A market maker in centralized finance is an institution responsible for ensuring liquidity in the markets they operate in. They do this by having vast amounts of capital which they use to make sure that market participants can always buy or sell the asset in the market. An automated market maker is a computer program that fulfills the same function, sometimes with a lot of capital, but other times with clever mathematics.
Our automated market maker uses the rules described in the section above to build the shape of the red line. At a high level you can think of each trade in the market as deciding the position and size of a red block. The red blocks across multiple trade merge together to build up the shape of the red line over time. Even though a trader may only use $1 to make a trade, the liquidity within the red block can be many times larger.
With many trades we end up with a picture like the one from the order book section which we are showing here again with some example blocks drawn in. It's important to note that we've skipped over a significant number of details here but hopefully this explanation was enough to give you a feel for what's happening behind the scenes.
Mathematically there is almost no difference in the aggregate behaviour of the markets, which is the most important thing. However, the markets on the Fragmynt Exchange Network do diverge from those in traditional finance on a number of points (most of which are related to companies).
In general, markets on FEN often do not give you ownership of the asset. This might seem like a big issue but it's actually only a problem if you want to vote in shareholder meetings for companies. Unfortunately, ownership does not often confer that much benefit unless you are a large institution. Let's take some time to go through each of the differences so that you can see for yourself.
1. Voting at shareholder meetings: If you buy shares in a company you usually have the right to participate and vote in shareholder meetings. Of course, if you invest in a company market on FEN then you won't get ownership of the company and thus don't have this right. However, most non-institutional investors (i.e. people who aren't banks or VC firms) don't vote in shareholder meetings, chiefly because their voting power is tiny compared to the large institutions that own most of the company.
2. Dividends: Since you don't own the asset on FEN, you won't receive a dividend or share of profit directly from the asset. This is again most relevant when talking about companies. However, since markets on FEN are so much more capital efficient than traditional finance, the money that has been saved (from paying fees to pointless intermediaries) is given back to long position holders in the markets periodically. Interestingly, this "dividend" from the FEN market will typically be much higher than the dividend you would receive from the company itself. This is because actual dividend yields are usually very small. Over the last 10 years, the average dividend yield on US stocks was just 2%. Furthermore, many of the largest and most popular companies (such as Amazon and Tesla) have never provided a dividend, instead opting to reinvest profits back into the company.
3. Stock/share splitting: Share splitting involves a company increasing the number of shares their shareholders have to make each of the individual shares worth less and thus more accessible for the smaller investor. They do this by issuing additional shares to current shareholders so that the value of each individual share is diluted. This is another situation where markets on FEN are an improvement over traditional finance. All markets on FEN are fractional, so you can purchase as small an amount as you would like, without the need for the complicated share splitting process.
One of the really amazing things about the Fragmynt market protocol is that you can have markets on anything. This means in addition to just companies (like Tesla or Apple) and commodities (like gold or oil) users can trade on people, concepts, countries, communities and more. The mechanics are exactly the same. All these markets work in the same way; investors make a decision on what they think the asset is worth and the collective decisions of all investors arrive at a single answer at each point in time. The more investors in the market, the more precise the market capitalization and liquidity distribution is.
Some people might find it uncomfortable to think about how to value some of these things, e.g. a person, but the process is no less principled than valuing a company, the mechanisms are just different. For example, for a market on Elon Musk we need to ask ourselves the question: "What is Elon Musk worth?". The answer could be:
1. His calculated net worth
2. The value of the companies he owns
3. The collective value of all of the products of the companies he owns
4. The value of all tv shows and movies inspired by Elon Musk - perhaps a proxy for his value to culture
5. The relative value compared to another asset in the same class, e.g. Jeff Bezos
The truth is that none of these answers are correct or incorrect, what matters is what most people agree on. As such, investing on FEN is in no different than investing anywhere else; you have to do your research, observe patterns in the market, look at how the price responds to events as they happen, etc. before you make your decision. It's important to remember that you are not trading on the value of the asset, you are trading on people's perception of its value. In fact, the value of the asset is actually what people's perception of it is. The really thing about markets is that the answer to the question "What is X worth?" is being both asked and answered by the market itself.
The price in the market on Fragmynt for something will in general not be the same as the price on another market where that thing is traded. This is because the markets started at different points with different participants and using a different underlying infrastructure. However, the absolute price is somewhat arbitrary and is mostly a result of unimportant factors. It is the relative price change that matters, e.g. +10%, -5% etc. With enough participants, the relative price change for an asset on Fragmynt will be the same as the relative price change on another exchange. This is because the market participants in both bases are responding to public information in the same way.
You might think there is a catch here. How come centralized exchanges have so many issues with liquidity and FEN solves it with an algorithm? The truth is that what is most important is information, not capital. And we haven't been able to get around that here. All markets suffer from information issues, its just that often they are hidden as liquidity issues.
The less people that are in the markets, the less "precise" they are. By this we mean that the price movements in the market are likely to be more noisy and unpredictable, especially in the short term. Even though the markets on FEN can have effectively infinite liquidity, we still can't get around the problem of how to distribute that liquidity in an accurate way. For that we just need many, many people. But fortunately, by building a new type of market that is fairer and more accessible, getting people to come isn't such an issue.
Hopefully you can now see the power of this new paradigm. Stick around for the other articles we release to learn more about how the Fragmynt Exchange Network operates under the hood!