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Op Ed: How Atomic Swaps Could Work for Stock Market Trading

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By Erik Kuebler

Traditional stock market trades can leverage the concept of atomic swaps to facilitate direct stock-to-stock trades without requiring cash positions.

Atomic Stocks Overview

In traditional stock exchanges, retail investors in public markets are unable to switch from one position to another without first going into cash. For example, an investor looking to trade his or her Amazon shares for PayPal shares must first exchange these Amazon shares for U.S. dollars, before buying PayPal shares with these dollars.

This style of exchange creates unnecessary friction and expense because of a) transaction costs incurred on the sale of the asset, as well as on the purchase of the new asset; b) U.S. dollar purchasing power exchange-rate risk; and c) transaction fees paid to the broker that the purchaser is using, as well as the bid-ask spread that exists for each publicly traded stock (which occurs on both the sale of the previously held asset, as well as on the newly purchased asset).

Atomic Swaps

In the context of cryptocurrency, atomic swaps are a proposed feature that could allow direct conversion between two cryptocurrencies without having to use a third-party intermediary or exchange. By employing hash time-locked smart contracts, atomic swaps guarantee that parties will deliver the currency needed for the trade, or else the transaction is automatically canceled. These “all or nothing” trades preserve atomicity because they either take place or are canceled immediately. For example, customer A could directly trade his or her bitcoin for customer B’s ether with full confidence that the trade will either take place or terminate if either party doesn’t deliver their side of the bargain.

Atomic Stocks

Harnessing the principle of atomic swaps, direct stock-to-stock exchanges (Atomic Stock Exchanges) enable retail investors to avoid the forced conversion into cash that occurs when selling a stock to USD just to buy back another stock.

It is a commonplace occurrence to switch between stock positions for retail investors and financial firms, and the prevention of touching cash allows for the avoidance of transaction fees that would normally be incurred when making these trades, and the cost-saving consolidation of the bid-ask spreads on both of these stocks into one bid-ask spread. While the larger cost saving would occur on direct stock-stock swaps, there are incremental cost savings on the bid-ask spread as well.

Atomic Stock Exchanges could feasibly work with large-cap stocks that have deep pools of liquidity, such as stocks on the S&P 500, and the liquidity needed for making the trades would be provided by high-frequency traders (HFT) who could make up the gap that exists.

This would squeeze HFT margins, but as a commodity business that provides a middleman service, we imagine they would facilitate this as a way to make incremental revenues (if they have no other options).

By focusing on the needs of the average retail consumer, we realize that in many cases, the sale into cash is forced and doesn’t correspond to what the investor actually wants, which is to simply switch from one highly liquid position to another.

Atomic Stock Exchange: Practical Example

Let’s imagine for simplicity that only the S&P 500 is available and that we want to rotate out of Google stock into Facebook stock because we think that Facebook stock has been shifted off of its fundamental value due to the Cambridge Analytica scandal. Therefore, we want to exchange our Google shares for Facebook shares; because they are both denominated in USD, there is a ratio of what one share is worth relative to the other share. On the market close of May 4, 2018, one share of Google is worth 5.95 shares of Facebook stock. In this hypothetical exchange, shares are fractional, and you are able to exchange one Google share for 5.95 Facebook shares and vice versa.

The “spread” in this case would be the amount of Google stock you receive when making this exchange. You would only receive 5.93 shares of Facebook when you are doing this exchange, and the market maker is getting 0.02 Facebook shares in exchange for facilitating this transaction. These shares add up over time in favor of the market maker and serve as their profit once they liquidate them.

This spread dynamic could potentially cause an issue since market makers are now being paid by stock instead of in cash, unlike with normal bid-ask spreads. However, this could allow market makers to profit via the appreciation of these shares during the trading day as well. However, nothing would prevent HFT from liquidating the shares they receive as cash immediately as well, provided someone takes this trade.

Exchange Dynamics

To start, Atomic Stock Exchanges would charge no exchange fees. Revenue can be made by selling order flow and the right to trade on this exchange to HFT. The way the buy and sell process would work from stock to stock could be: when a sell order is placed, it is specified which position the firm would like to exchange into, and provided that this trade is available, it is filled by simply swapping shares. This is where HFT could be invaluable as a market maker and be able to profit off the spread. This would serve as a way to make a profit, and many exchanges try to obfuscate the fact that they make money off retail investors doing so.

Questions Worth Considering

What is the main issue that would have to be overcome to create an Atomic Stock Exchange?

It’s critical to figure out how to enable the purchasing of decimalized amounts of shares and how to pair users that are actually looking to swap shares with each other. In private markets, counterparties have broad control over their trade arrangements, but in public markets this utility hasn’t yet been harnessed. In other words, for atomic stocks to work, an Atomic Stock Exchange would have to create decimalized shares. When we consider that for a retail user of E-Trade or Charles Schwab, the cost of going from Amazon to Facebook is selling one and buying the other, each of which carries a transaction fee, and we see that this could be a huge cost savings for the average retail investor, even if a service had to be paid on the back end to enable a decimalized share service to exist. However, for an Atomic Stock Exchange to be profitable, it would have to support massive volume.

Is decimalization of shares in public markets the equivalent of decimalization for stock prices?

Before 2001, all stock prices in the U.S. were quoted as 1/16 of a dollar, creating opportunities for arbitrage, but also creating massive inefficiencies within markets as well. Decimalization has led to tighter spreads because of the corresponding smaller price increments and movements. With decimalization, the minimum price movement is now one cent, allowing for tighter spreads between the bid and the ask levels. For example, shares could be decimalized out to five decimal places, allowing for the equivalent trading of shares.

Would the theoretical lack of (or less) cash be an issue for this exchange?

Many exchanges make money by putting cash that hasn’t been invested into money market accounts. An Atomic Stock Exchange could allow for these kinds of cash holdings as well.

What about liquidity?

Atomic Stock Exchanges can be built on top of existing exchanges, meaning that retail investors can still switch to cash positions if they wish to do so.

Do any kind of similar trades already happen?

Institutional investors can already execute paired trades that never expose them directly to fiat currency. But retail investors miss out on this opportunity.

This paper is part of a research project being developed by Erik Kuebler and Oscar Avatare at the University of Washington. If you have any feedback, suggestions or questions, please email ekuebler@uw.edu or oavatare@uw.edu.

This article originally appeared on Bitcoin Magazine.

Bitcoin Magazine is the oldest and most established source of news, information and expert commentary on Bitcoin, blockchain technology and the digital currency industry. Since 2012, Bitcoin Magazine has provided analysis, research, education and thought leadership at the intersection of finance and technology.

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