Vega Protocol is disrupting the regulation of markets
Part 1 in a series on Vega Protocol as a disruptive innovation
My thesis is that Vega Protocol’s fundamental disruptive innovation is the commoditisation of trust in derivatives markets. The infinite reproducibility of a safe marketplace, which includes leveraging.
I recently took Clay Christensen’s course “Disruptive Strategy” through Harvard Business School Online. Highly recommended, even with the high price tag.
Vega Protocol is a network for running order-book based DEXs, which allows leveraged trading and creation of derivatives markets (futures, options etc.), running entirely on-chain.
Blockchain’s central innovation is the ability to create trust-less systems, and Vega is the ultimate manifestation of this in the derivatives exchange space.
Vega is disrupting financial regulators
You cannot disrupt yourself, so who is Vega disrupting? The CFTC* is the traditional source of trust in derivatives markets. Laws and KYC allow exchanges to manage counter-party risk and hostile behaviour.
*The Commodity Futures Trading Commission is the SEC of derivatives.
A note on trust in markets:
Trust is the ultimate foundation of a market — the trust that you are trading your real value for others’ real value. Two agents may appear to have enough funds in their exchange accounts to trade, but if the market around them collapses, then their trades do not reflect real value. The value has dissolved behind the scenes, probably from the market abstracting away risk, continuing on as if everything is ok, until all hell breaks loose. Think of the 2008 housing crisis. Traders who are aware of this risk can use it to make money off the market’s pool of collateral.
Protection from losing money: A regulator’s pride and achilles heel
KYC, centralised exchanges and regulations from the CFTC exist to encourage trust and accountability. Their current model is effective, but with the side-effect of abstracting away risk and delaying losses until a larger, unexpected event occurs. Instead of getting hurt weekly, for example, they make you feel safe until the end of each year, when you get pummelled 5 times harder, and quickly forget about it thereafter. Vega favours a more immediate awareness of risk, where you could get hurt more often, but with much lower consequences*. Importantly, you set the limits on this downside risk through the amounts you deposit.
*Increased fragility of components → increased anti-fragility of the system*
On Vega, you can’t lose more money than you put in
— someone can’t come to you for your house.
Vega Protocol is able (hoping) to safely run markets with leverage by maintaining insurance pools, running frequent batch auctions and monitoring market-level and individual risk through smart-contracts each block (every second or so). Traditionally, credit risk is monitored daily, and the capital and control a central exchange has to liquidate positions isn’t so well defined. This leads to parties sometimes owing far more than they originally deposited.
Chasing people for money and maintaining laws is expensive
Nullifying the need for this through a smart-contract based protocol should save a lot of money. Profit margins for Vega will take advantage of this gap, until the SEC and centralised exchanges simply can’t compete and are forced out of the space.
Think about all the manual audits and maintenance of government office buildings that Vega doesn’t have to pay for. Most of the team works from home anyway! To think a cornerstone institution in society can be disrupted by less than 20 people working from their living rooms is incredible.
Disruption of regulatory bodies means disruption of Centralised Exchanges.
Centralised exchanges (CEXs) have their own SEC-compliant trust modules integrated into their companies. There might still be a place for some centralisation in exchange business and design, but the SEC module will be replaced by the Vega module.
Explicit vs implicit insurance pools
Vega’s protocol manages market-level risk partly by building insurance pools for each market. The pools are added to from the leftovers from forced liquidations when someone gets a margin call. Then when kombucha coin is mooning and everyone who has shorted is getting rekt, the insurance pools are deployed automatically so that positions can be closed before they have lost more than there is money associated with the account. Think of the insurance pools as walking sticks to help market makers cross the wider spreads to fill your desperate buy order when there is an aggressive dip. It is liquidity insurance.
Some CEXs have insurance pools, as pioneered by BitMex. Vega’s innovation is to put this entirely on-chain, and is monitored and added to every block.
Vega also reduces the frequency of needing to deploy the insurance pool through activating batch auctions when there is high liquidity risk. Batch auctions are a different price determining mechanism better suited to stressed conditions. They are a normal part of traditional markets, used on market open every day.
Legacy finance plus
Vega have kept most of the tried-and-true elements of legacy financial markets, but removed the need for centralised bodies to play parent to traders, both big and small. One look at how governments keep banks accountable for the risk they aggregate should tell us that we should be placing our trust elsewhere, in an anti-fragile system, and the team at Vega are on a mission to solve this.
