TL;DR Technology can inform regulation, we can design systems that are easy to regulate, because they are self regulating. It’s logically simpler to build systems that both define, and compel, appropriate behavior; this is as opposed to building systems which then require entirely disjoint efforts to assure compliance.

Adverse selection in traditional markets and the concept of uninformed order flow, as described here in an article from the CFA institute, illustrate some of the room for improvement with regard to market infrastructure. Not only can crypto markets be built to be more secure and reliable than traditional, centralized financial institutions, a new standard for acceptable behavior from market participants can be defined. 

Currently, in the world of TradFi, uninformed order flow is sold to firms (via PFOF and similar models) with the tech, algorithms and resources required to make informed bets on the short term price fluctuations of assets. This internalization of order flow is considered a legal, if controversial, practice. The controversy of course stems from the fact that retail traders on platforms like Robinhood are generally considered to be uninformed traders, in the sense that they aren’t trying to predict price movements on small time horizons. Payment For Order Flow (PFOF) and similar practices are quite possibly awaiting regulatory reckoning.   

One relevant regulation is the The Order Protection Rule (also known as Trade Through Rule), which creates an NBBO (National Best Bid and Offer) system. Unfortunately, idiosyncrasies of order arrival and ordering allow for prices offered beyond the NBBO, which  would potentially express an attempt at capitalizing on internalization so egregiously that the customer receives a worse deal than they would on the market. It seems reasonable to expect, and demand, better economic outcomes than this. A National Best Bid and Offer (NBBO) should help markets become more transparent and fair in virtue of providing a benchmark for what counts as an acceptably fair price. If brokers offer deals worse than the NBBO, there are potential legal consequences (we touched on this recently). This regulation helped to move the conversation forwards with regards to making markets fairer. However, since industry actors with advanced technology, and sophisticated models, are able to develop and act on more nuanced understandings of the markets, it is possible to reliably turn a profit by facilitating trades that are either; just outside of the NBBO (by a sufficiently small margin that people with less sophisticated models struggle to prove is not), or a function of elapsed time. 

Were the crypto markets to have an NBBO, then they would still have the same problem as more traditional markets (which of course also have an NBBO). The challenge is to build systems that don’t reliably give one set of participants predictable advantages over others; the challenge is to build an algorithmically level playing field. For the past decade or so, reasonable and well informed people have had meaningful concerns about High Frequency Trading; asking who it benefits, how and at what cost. We can wait for regulators to drive a level playing field, though history suggests that not only will the regulation lag behind the technology, it will only be (at best) partly effective in its aims.  

A compelling addition to the industry would be a platform that defines appropriate behavior for all participants. This might come in the form of algorithmically setting rules on how Market Makers acquire and administer access to order flows. We can leverage technology, such as smart contracts, to compel all Market Makers to play by the same rules. Much as there’s no sense tempting an honest person, there’s no sense tempting an honest market participant (or algorithm, for that matter).