Patrick Young and I did a podcast recently. If you don’t know him, he wrote a book back in 1998 called The Capital Markets Revolution. He traded at the LIFFE and saw electronic markets along with the effects of electronic markets long before anyone else.
We chatted about how a trader becomes an angel investor. One question he asked me was about exchanges and it invariably led to talking about FTX.
When the crypto space started, a lot of the companies were basically analogs of processes that were already done in the “institutional” or “regular” monetary space. One part of the regular space that easily found its way into crypto was an exchange model. Why? It’s because exchanges are so darned efficient and useful.
The problem was, many of the people starting exchanges thought they knew what they were doing but they actually didn’t. They were of the “go do it fake it till you make it” crowd.
Many of the people investing in these exchanges thought they knew what they were doing, but actually didn’t. They thought, “I have an elite school MBA, I can figure out any business model.”
The exchange business is multi-layered, and very very complex. Everyone sees prices and thinks about economics, transparency, and price. That is important but more important is the backbone that goes into delivering that transparent price. It’s not the matching system.
FTX failed for many reasons but a core one is they had no idea what clearing really and truly was. CME Chair Duffy called out SBF in a one to one meeting and I would have done the same thing but probably not as eloquently as Duffy did.
I was reading this article in the WSJ about the startup Open Exchange and the travails it is having after coming out of the ashes of failed hedge fund Three Arrows.
Su Zhu and Kyle Davies, who ran the collapsed crypto hedge fund Three Arrows Capital, are among the founders of Open Exchange, which wants to let its customers trade bankruptcy claims on failed crypto companies, including Celsius, FTX and even Three Arrows itself. But the fledgling venture, which went live in April, has been hit with numerous problems since it launched.
Open Exchange, also known as OPNX, has been reprimanded by a financial regulator, threatened with legal action by institutions it said were its investors and was rejected by some market makers. At the root of some of these problems are the damaged reputations of Zhu and Davies, which haven’t recovered from the collapse of Three Arrows last year.
The founders, Su Zhu, Leslie Lamb, and Kyle Davies, aren’t exactly heavily experienced in exchanges. They might have traded a little bit, but I can tell you from experience that just because you traded doesn’t mean you understand how to run and operate an exchange. I traded from 1988-1998 before I went on the Board of CME. I knew some things, but it wasn’t until 1998 that I began to really learn the guts and glue of how an exchange operates. Believe me when I tell you, I got an education.
To this day, I don’t know everything about everything. But, I know enough. I know what questions to ask to stay out of bad deals which is a lot of the battle when you are investing.
You might drink a bunch of Red Bull and have skull sessions all night, but just because you have a good idea doesn’t mean you can execute it. Ideas are cheap.
I also find that a lot of service providers come to a hot industry promising all kinds of things but actually knowing very little. They pay their tuition to learn by charging you. Lawyers and other service providers in crypto were great examples. I suppose many of them are off to find opportunities in artificial intelligence companies today.
I passed on almost every single exchange I ever saw a pitch for. I invested in two, and frankly one wasn’t going to be an exchange in the same sense as we think about exchanges. OpenFinance was originally just taking a paper real estate market and digitizing it. It wasn’t until we got into it that it went crypto, and my introduction to a great SEC lawyer made it the first exchange that got approval to trade security tokens. Of course, the SEC crushed that market so there was no volume. The guys that started that company knew little about exchanges and a lot about the real estate market. We eventually brought in a trader who knew exchanges and the back office to run it.
The other exchange I invested in is Bitnomial. They are still alive today and growing. They are the only CFTC-regulated futures market for physically deliverable cryptocurrencies. The people at the top there all had deep experience not only in trading but in the back office operations of trading firms. That back office experience is super boring, not sexy, and not lucrative. But, unless you have it you cannot run an exchange.
By the way, unless you know how it works, and how the execution happens, you shouldn’t invest in a pure exchange either. The other thing you can do is hire someone with that experience to look at the deal and talk to the people involved. Absent that, tread carefully.
I have never done a medical deal. Why? I know what I don’t know.
Exchanges are not consumer products. They aren’t a SaaS play. It’s not something that is easily devolved into Porter’s Five Forces and analyzed.
There are times when exchange solutions are proposed and they won’t work. That’s especially true if the people involved just had a good idea with no idea of how to really execute it.
We know what we know.
Some of us know what we don't know and act accordingly.
The problems are created by the people who don't know what they don't know and just blindly march forward.
JLM
www.themusingsofthebigredcar.com
Technology has camouflaged the mechanical functions of an exchange. You know how an order flows because you traded on the floor and could literally watch the ticket paper float from place to place until it had completed its journey. Now, that just happens. Poof. Instantly. And you can’t see the clock work.