DeFi Reinvents the Bucket Shop for the Better


Modern futures markets originated in the U.S. Midwest during the mid-1800s and were originally democratic institutions that accepted all comers. The legal foundations for enforcing futures contracts were shaky, and the regulatory foundations non-existent. But as futures exchanges matured over succeeding decades and became more important economically, they began to exclude the hoi polloi with larger lot sizes, margin requirements and membership fees.

By the 1870s, traders excluded by these financial restrictions (or by social, religious, ethnic or gender classifications) organized into decentralized networks that came to be called “bucket shops” because they bucketed orders among customers rather than offering or promising delivery of the underlying commodities. Even people who could have traded on official exchanges often preferred the bucket shops for their longer hours of operation, customer-friendly conditions, lower overhead and more convenient locations.

This is precisely the story we are seeing in decentralized finance – or DeFi – now, where people unable to open brokerage accounts or put off by account minimums or burdened with too many regulations prefer to trade directly with other investors on the blockchain. There are risks to this, and Nassim Nicholas Taleb is correct to warn anyone considering trading crypto stock tokens to learn the history of bucket shops. But that history reveals benefits to go along with those risks. (I’ve known Taleb for 36 years and have learned much from him. I always find his comments provocative and usually right .)

DeFi Reinvents the Bucket Shop for the Better

Why do many people have a negative view of bucket shops today? In the 1890s, organized exchanges began legal and public relations campaigns to have them outlawed. One reason was that bucket shops were growing and exchanges didn’t like the competition. Another reason was that exchanges were being threatened themselves by people who claimed futures trading was gambling. The exchanges’ defense was to emphasize the possibility of physical delivery of their contracts — even though it was rare — and to point to the bucket shops as the gambling dens.

The campaign involved making up false etymologies for the term “bucket shop,” usually involving unpleasant images such as homeless street urchins selling dregs from waste buckets of disreputable saloons. More seriously, the exchanges paid newspapers to exaggerate stories of financial scandals at these unregulated shops, and if that failed to invent stories.

The first lesson modern traders should learn is there was quite a bit of fraud and scandal at these shops. But traders should also reflect there was a lot of chicanery at official exchanges as well. Although no statistics exist on the subject, I’d hazard a guess that the average amateur trader stood a better chance of making money at a bucket shop than with official futures brokers. Yes, there was a greater risk that your bucket shop would go bankrupt or turn out to be a front for crooks. But with official exchanges, the money extracted by fees and shady execution practices could virtually guarantee long-term losses for small customers.

The second lesson is that a DeFi stock token is not precisely the same as owning a share of stock. For one thing, most do not pay dividends, so they are like stock futures contracts rather than the stocks themselves. Of course, tokens come without voting rights. No one has offered tokens with automated ways to handle corporate actions such as stock splits, so you have to trust the pool organizers—and that also means pool organizers can steal the collateral. Even if everyone is honest, the token will not track the stock for very large moves—how large depends on the size of the collateral pool, an important parameter for stock token traders to monitor. Profits (if any) are generally paid in stablecoins, which have their own risks.

The disadvantages of DeFi stock tokens outweigh advantages for long-term investors legally allowed to open regulated brokerage accounts, especially with the rise of customer-friendly places that allow fractional share trading. But day traders and people turned away by brokerage firms have a compelling alternative with tokens.

I predict an orchestrated campaign by regulated financial institutions and regulators to suppress these tokens, and also that the campaign will fail. I think a lot of retail short-term trading will move to tokens, and the next logical step — token version of exchange-traded funds — will be a very big business in a few years.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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