In-depth analysis: constructing the market microstructure of NFT

Author: 0xc3f1

Source: black mirror

I've been researching the market microstructure of NFTs lately, and recent discussions on the merits of platforms like Sudoswap have highlighted some inherent tensions between the current NFT audience and the asset class of the future. A huge wave of platforms is coming, and they will bring stronger market structures for NFTs for traders, and soon for other niche assets as well. Over time, the evolution of the NFT market structure due to technological innovations and new models of financialization will provide a useful aid in understanding trends across all markets.

In this post, I will highlight why inefficient markets exist, why market microstructure matters, and why NFTs are not immune to arbitrage. Inefficient markets are always arbitraged by smart traders who see a profit opportunity. In many markets, this could take decades, if not centuries. The inherently digital nature of NFTs accelerates this process and accelerates this timeline, as we have seen with Bitcoin and later tokens. I will also share some brief thoughts on the future of culture as capital and cultural arbitrage from a market perspective, and how efficient markets can help eliminate the fraud that is so prevalent in emerging asset classes.

What is an inefficient market

The emergence of inefficient markets is due to information asymmetry, high transaction costs, psychology and human emotions, and various types of market manipulation, including collusion, insider trading, etc.

Many "unique" assets, such as NFTs, but also real estate, collectibles, fine wine, art, etc., suffer from highly inefficient markets. However, technology can improve efficiency. Real estate is starting to become more efficient thanks to new platforms like Zillow, Open Door, Compass, etc. These new platforms present unified real estate information at scale - minimizing information asymmetries, simplifying transaction execution - minimizing transaction costs, and better workflows to manage these assets at scale. This has attracted more companies to engage in real estate transactions. In the past highly specialized real estate investors with their own internal systems and processes dominated the asset class, but the availability of more general tools and market infrastructure has enabled more generalist investors to build real estate investment strategies to Take advantage of inefficiencies and market arbitrage.

The NFT market is also inefficient, in part because our understanding of NFTs as assets is largely limited to the subjective world of "art". The biggest driver of inefficiency in the NFT market is the lack of a market microstructure that can make transactions efficient.

What is Market Microstructure

It sounds fancy, but market microstructure is just an essential detail of how trading works in a particular market. The processes, technologies, and platforms used at each stage of an exchange affect order book depth, transaction costs, clearance volume, trading behavior, and several other important market indicators. The study of market microstructure is all about understanding how these trading mechanisms affect price formation.

Today, NFTs lack a formal, unified market microstructure, making them a challenging asset class for market participants to trade at scale. However, there is an ecosystem of tools that make NFTs useful for quantitative trading strategies such as momentum, arbitrage, and volatility, by eliminating the need to pick and choose individual components, enabling programmatic buying and selling at scale without viewing or “valuing” NFTs. This has huge potential for NFT trading volume and liquidity.

To break down the market microstructure, it helps to understand the high level of the transaction life cycle. The following figure shows the simplified transaction life cycle of the current NFT market and some challenges it faces:

Market structure-focused firms can address one, several, or all aspects of this workflow.

For the NFT market to grow and expand with the asset class, more protocols and platforms are needed that enable each stage of the transaction lifecycle to work more efficiently. Ideally, these modular components should come together to form an automated, scalable workflow that enables all types of market participants to deploy a variety of trading and investment strategies, whether collectors choose to hold the Holy Grail as a long-term favorite Part of it is that arbitrageurs short-term trade tens of millions of dollars in inefficiently priced NFTs to earn profits.

Today's NFT ecosystem caters to collectors and hobbyists alike. Tomorrow's NFT ecosystem will serve a wider range of utilitarian and speculative traders through a complex set of market micro-protocols and platforms. This does not mean that collectors or individuals will cease to be market participants - it just means that the way they interact with the market will change and where they find an advantage will change as price discovery changes. It could lead to a massive wealth transfer that would benefit early market participants and collectors and allow the NFT market to grow exponentially in size. This process is called financialization and is part of the evolution of every market and asset class.

NFTs are not immune to arbitrage

Naturally, talk of the financialization of the NFT market has unnerved some, especially those currently benefiting from the aforementioned inefficient markets. One of the core claims is that the NFT market can never be traded by quantitative analysts and algorithmic traders due to some divine wisdom that only brilliant thinkers like "poopy69nfftfan" or "JPEGcollector420" can intuitively perceive. In my opinion, most NFT trading market participants today are bad traders, they are profit driven, but inefficient and erratic.

Arbitrage is a natural part of all markets. When traders see an inefficiency in the market, they design a trading strategy to profit from it and execute it over and over until it runs out. In order to take advantage of geographical arbitrage, the early merchants took huge material and financial risks and drove a caravan of camels loaded with spices along the Silk Road, accumulating wealth for generations along the way. In 2022, after our Satoshi Nakamoto, savvy traders who are considered to be cartoon PFPs will build strategies to use NFT arbitrage, sell jpegs at the speed of light, and also accumulate generational wealth in the process.

The distinction between fungible ERC-20 tokens and non-fungible ERC-721 tokens is largely a distinction that clarifies the functional economic use or "monetaryness" of each asset. To some extent, it may also determine the market microstructure of each asset, although over time, I expect most of these will converge, because this convergence will lead to more liquidity. This trend is accelerating as Uniswap integrates NFTs through the acquisition of Genie.

ERC-20 tokens are useful as "currency" because they can serve as a unit of account, a medium of exchange, and perhaps a store of value. This makes it easier for us to understand and predict the evolution of the market microstructure of these assets, since our current behavior towards currencies and monetary assets is already based on the belief that market efficiency is a positive property. We don't question the arc of progression when it comes to these assets because they fit the mental models we've been brought up since childhood.

ERC-721 or non-fungible tokens are not useful as "currency" due to the unique nature of each asset, but that doesn't mean they are somehow immune to the same evolutionary arc from a market perspective. Cultural narratives around NFTs are an effective mechanism for driving broader audience participation in the market than monetary assets, as culture is more interesting and often easier to understand than finance.

However, this medium does not change the message - like all on-chain markets, NFTs make themselves incredibly conducive to efficiency-driven trading strategies.

Imagine an effective NFT market

With all that said, what would an efficient NFT market look like?

price discovery

How do you collect data on NFTs? How do you know what the price of an NFT should be? How do you find the best price for your trade? What do you think about an integrated "order book" that shows all listings for all collectibles in one simple interface?

Currently the most used discovery platform is OpenSea, however, very little data is available in the OpenSea interface, providing little insight beyond what can be collected on-chain. OpenSea also restricts you to viewing listings on their platform, which do not always represent the entire contents of the order book.

Genie is a market aggregator that takes price data from several different marketplaces such as OpenSea, LooksRare, etc., and integrates price data from marketplaces, and can also add assessment data from Upshot*. Upshot* itself integrates machine learning algorithms with a wealth of qualitative and quantitative data, available through an API, along with rarity data from RaritySniper for those who still value rarer data.

Data poor vs data rich

However, all data services, aggregators, and marketplaces today focus solely on aggregated lists or sale prices. We haven’t seen the development of structured data feeds or aggregators that show market depth, including bids or bids, and the settlement prices for those bids. Therefore, it is difficult to determine market depth. As shown in the figure below, market liquidity is determined by order depth, while price is determined by the range of clear orders. The price discovery picture is very incomplete without knowing the sum of the spreads across exchanges and OTC.

Market Depth Brings Liquidity

There are a plethora of price discovery platforms currently being built, with varying degrees of usefulness to traders. Many games are more oriented toward collectors, focusing on traits, rarity, and other data points that lack actionability. The emergence of price discovery platforms focused on market insights and asset-specific data is significant. Upshot is currently leading the way in enabling arbitrage trading strategies, although we have yet to see a fund or product that integrates this data into a purely arbitrage-driven strategy. Maybe someone will make it soon...

I also want the over-the-counter (OTC) market to become more efficient. Just as Paradigm* already offers large scale OTC quotes (Request for Quote) for Bitcoin and other cryptocurrencies, we need a bulk RFQ platform for OTC NFT trading. I want to be able to bid on hundreds of NFTs at once, using specific search parameters, rather than placing hundreds of bids on different platforms individually. Maybe an on-chain messaging solution will help make this easier, savvy snipers already use wallet-level messaging to pinpoint offers, get the best price, and avoid market fees.

transaction execution

Once I identify the asset I want to trade and feel confident in price discovery, I want to execute the trade. Today, many marketplaces and aggregators bundle trade execution, price discovery, and settlement into one interface, and some NFT series even build their own protocols or interfaces for trade execution. For example, LarvaLabs embeds its own CryptoPunks marketplace directly on its website, while EtherRocks can only be traded on the EtherRock website because there was no market for these early NFTs when they appeared. Today, efficiency requires aggregation. Sudoswap is one such building block that makes aggregation and execution at scale simpler by developing liquidity pools that allow market making across entire NFT families through bonding curves that respond to market dynamics.

In the example above, one could sell NFTs for ETH on an exponential bonding curve. Sudoswap also allows you to bid on all pools in one NFT series, which means you can bid on multiple NFTs with multiple liquidity with the click of a button.

Uniswap has also added NFTs to their protocol, which will further integrate the token and NFT markets and enable more applications to utilize Uniswap’s liquidity. The key is to make execution simple, programmatic and scalable regardless of order type.

Right now, the best solution for a large acquisition is to: (a) use OpenSea, Genie or (b) find a major shareholder, negotiate a large acquisition, and settle the DVP (delivery vs payment), which has its own unique risks in the settlement part .

Today, there are very few over-the-counter brokers engaged in NFT transactions, and most large transactions tend to occur between collectors of specific collectibles. Sourcing at scale is a challenge, but I expect we will see more professional OTC brokers and market makers pop up who trade at scale in both off-chain and on-chain NFT markets, specializing in markets that do not affect market prices liquidation or accumulation of sizable positions. As ever, the main challenges with OTC transactions are the opacity of such transactions and the integration of market data into pricing models, especially if the transactions are done off-chain.

Margin and Liquidation

One of the biggest constraints on NFT liquidity is the clearing and settlement process, and the requirement of trading venues to provide collateral when you place an offer. Let's say I want to bid 100 CryptoDickbutts in one batch bid. OpenSea will ask me to wrap ETH into wETH, and then place 100 bids, locking my wETH for several days. While I can bid the smallest amount of wETH to reduce the capital drag, it also means I may have multiple unclear bid matches. This is highly capital inefficient and can lead to suboptimal execution. In order for NFTs to be more liquid, we need the ability to bid with lower collateral requirements than any other asset.

Perhaps an on-chain clearinghouse that enables credit management like Credora* could be integrated to help drive better capital efficiency. Perhaps we will see the emergence of prime brokers, who provide short-term credit for such bids. But structurally, this issue may be one of the biggest challenges to solve, especially for on-chain transactions. If NFT liquidation moves to a hub-and-spoke model with daily settlement instead of instant settlement, the process could become easier, but also more centralized. However, efficiency and decentralization are not always the best of friends.

In terms of margin, platforms like NFTFi enable NFT holders to use their existing NFTs as collateral for more liquidity in trading. The upcoming Astaria* promises to provide instant liquidity to NFTs by unifying the lending side into one yield payment pool, rather than fragmenting it through recycling. Over-the-counter firms and prime brokers also accept NFTs as collateral for loans, and it’s worth noting that Genesis provided $6 million in January 2022 to NFT fund Meta4 as collateral for the NFT series, which the fund subsequently used to More NFTs were purchased. This is called leverage, and leverage is the lifeblood of modern financial markets.

Today, acquiring leverage is costly and often occurs outside of existing order flow. You have to visit a separate platform, transfer your NFTs to an escrow account, and manage security deposits carefully. Integrating margin directly into the trading process can help traders use leverage more consistently and on a larger scale, but lenders will need better pricing oracles, back to step one, price discovery is not only important for traders.

The huge opportunity for NFTs lies in improving capital efficiency. Systematic trading requires capital efficiency because arbitrage margins tend to diminish over time and your profits must exceed your cost of capital. For example, if you can consistently take advantage of 10-15% short-term price arbitrage, your borrowing costs must be below 10-15%, preferably by a substantial margin, so that you can book profits, making this practice become more profitable. Additionally, an important metric for portfolio managers is ROIC, or "return on invested capital." If I have 100 ETH but I can only trade 1x without leverage and get 6% arb, my ROIC will be much lower than if I had 100 ETH but can leverage 4-5x to amplify me The return per dollar deployed, since the 6% arb is now several times over.

Settlement and post-trade reconciliation

The final step in this cycle is to settle the transaction, that is, the exchange of assets, and then ensure that the settlement happened as agreed, which is called reconciliation. The biggest benefit of the on-chain market is instant settlement, and NFT is an important proof point for collectibles, artworks and other unique markets where settlement is not standardized, costly, or requires special custody. Today's NFT settlement uses a smart contract that enables atomic swaps without the need for a trusted third party to coordinate delivery versus payment (DVP), which is a huge advantage over other types of assets. NFT origin is easy to track and its authenticity can be verified on-chain.

Given the informal and non-standardized nature of the steps above and the lack of standardized data formats and APIs, the least structured part of the NFT transaction lifecycle is reconciliation. Collecting data and integrating it into risk management or back office systems is often a manual and labor-intensive process that requires data aggregation, cleansing and standardization. Perhaps tools like Cryptio* can support back-end functions of crypto assets more broadly and NFT reporting modules will also be developed, but then monitoring locations in real time and assigning value to them will require better pricing data - back to step 1, Price Discovery! Tracking open auctions and offers, as well as any margin requirements, will require aggregating all positions into a firm-level view, using real-time data feeds and also allowing for real-time programmatic execution when risk parameters or thresholds are crossed.

Over time, I'm optimistic that more standardized data APIs will make it easier to manage reconciliations without much manual work, and will make it easier to apply tax and accounting overrides so that Real-time tracking of profit and loss statements is possible. For example, the widely used FIX (Financial Information Exchange) standard is a vendor-neutral electronic communication protocol developed by and for the trading community in 1992. FIX has become the messaging standard for order workflow communications and regulatory reporting, and the FIX API ensures your data is compatible with every trading, accounting and risk management system built for modern capital markets. As a common data layer, blockchain's inherent structure makes extracting data easier, but until a more formal NFT transaction workflow is defined, it is difficult to determine how best to aggregate and coordinate data across protocols, platforms, and applications .

While reconciliation may seem like an unattractive business at all, it's very tricky because all companies need it and build processes around it, and it can be a huge recurring revenue/cash cow business.

Summarize

In the long run, traders may not only trade the underlying NFT, but a new synthetic derivative or prediction market will emerge, allowing traders to make directional bets instead of trading the underlying product. In the short term, however, the opportunity is fairly clear.

Those details aren't out yet, but any market fan can see what's coming. The microstructure of the NFT market is slowly becoming more defined and orderly, and will create opportunities for new types of market participants as well as operators and investors who own the underlying infrastructure. What remains to be seen is what parts of this transaction lifecycle will be built and monetized as stand-alone platforms or protocols, and whether any players try to build or acquire the components needed to build a vertically integrated NFT transaction workflow.

One last note – many say that arbitrage-driven traders entering the NFT space is a bad thing. The infusion of financial capital into cultural capital has been a major trend of the past 20 years, and while this has been achieved indirectly through the rise of social media and internet influencers, it will continue to gather momentum and become more directly visible.

Coinbase ranks in the top 10 among U.S. depository banks. Anonymous traders have amassed profit and loss statements that rival the CEOs of Wall Street's most famous traditional trading firms. Soon, pseudonymous cartoon characters will dominate the NFT market, releasing beautiful jpeg images of original sources.

Whether you’re throwing a few ETH or billions, on-chain marketplaces have started to level the playing field by enabling anyone to be a market maker or liquidity provider.

All inefficient markets become more efficient as information asymmetries are reduced and market structures improved. The idea that cultural capital is somehow immune to this model is willfully ignorant at best. Algorithms already dictate how you consume culture. Don't fool yourself into thinking you have taste. Just look at the NFT.

Create value around cultural consensus. Thanks to tools like Upshot, Context*, Flip, etc., emergent consensus in the NFT market is a pattern that can be discovered and presented through quantitative and qualitative information. Today's cultural capital has been arbitraged, it's only done behind closed doors by a small group of insiders. Why not make this process public and democratized by providing transparency and tools to benefit a wider range of market participants?

Some might say it's dystopian, but it's not. Markets are becoming efficient, and technology is only enabling this in new ways. The real problem, arguably, is that efficient markets don't benefit insiders—there's a lot of fraud in inefficient, opaque markets for things like wine, art, and collectibles. We see this in the capital markets too - every wave of technological innovation brings some scammers to sell access and insider information - we see it in tokens, stocks, and now NFTs. Fraud and financial bubbles will always exist, it is an inevitable part of the market due to human nature, and no technology (currently) can change that.

So when people protest the pace of progress, it is often because they themselves fear the structural power shifts that change brings. You can go against the trend of progress, or you can embrace it. History does not erect statues for critics.