Decentralization and Disintermediation in Blockchain-based Marketplaces
Marketplaces are essential in our current society. They give traders an environment to exchange goods, services, and other resources. Today, there is a myriad of marketplaces where many different services and goods are being exchanged. Most of the marketplaces that we are frequently using, such as Amazon, Uber, and Airbnb, are under the full control of a single operator that defines the ins and outs of the market platform. Blockchain technology has challenged this status quo and enables the decentralization and disintermediation of existing marketplaces.
In this blog post, we describe how blockchain technology can reshape traditional marketplaces. We first put a perspective on how marketplaces have transformed during the past few decades and then explain how blockchain can enable decentralization and disintermediation of existing marketplaces. Blockchain-based marketplaces are the central topic of my PhD dissertation, which contains more technical details on this subject.
The Rise and Dominance of E-commerce Markets
Before the advent of information technology, trade was mostly conducted on physical markets where prospective traders would gather, negotiate, and trade their goods, services, or resources. The rise of the Internet and the development of information technology have enabled electronic marketplaces that leverage the Internet to conduct trade globally. During the 1970s, the first basic electronic markets emerged, but they were used by a small group of businesses exclusively since Internet access was not common yet. It was not until the 1990s that companies such as Amazon (1994) and eBay (1995) opened their virtual doors and made e-commerce accessible to the public. These platforms allow the global trade of physical goods, all from the comforts of one’s home. The operator behind the electronic market provides various services during the trading process, for example, by storing profile information of traders and by processing a payment when two users are trading. The domain of e-commerce enjoyed explosive growth during the 2000s when many new market types emerged, e.g., media streaming, online food ordering, and financial services. The impact of e-commerce is unequivocal and is expected to total almost $5 trillion this year.
The sharing economy makes up a large part of the electronic marketplace landscape. Companies acting in the sharing economy, such as Uber and Airbnb, provide the infrastructure for the direct exchange of personal resources, such as houses and cars, between strangers. Whereas this form of peer-to-peer commerce was unthinkable just a few decades ago, “airbnbing” your apartment nowadays can be a lucrative business model during a tourist season. Due to the impact of the sharing economy on the global economy, it is widely considered a key milestone in electronic marketplaces.
Most, if not all of the electronic marketplaces we are using daily are under the control and supervision of a single market operator. We refer to these markets as centralized. The market operator has the following two key roles:
- Providing infrastructure and software. The market operator provides the necessary infrastructure and software for end-users to participate in the marketplace. Traders use the market software to place orders, discover products, and meet other traders. From a technical perspective, centralized market infrastructure is relatively straightforward to setup, and the operator can closely monitor the market since it has first-hand access to all market information. All communication between traders proceeds through the servers provided by the market operator.
- Reducing risks. Despite the popularity of electronic marketplaces, trading on such platforms is not always without risks for end-users. These risks particularly pertain to e-commerce, where the barrier to committing fraud is lower due to the lack of physical presence and interaction. For example, a trader can deceive a buyer into paying for some goods and then disappear without sending the goods to the buyer. This kind of fraud is also called counterparty fraud, and it is a major concern in electronic marketplaces. An important responsibility of the market operator is to reduce counterparty risks between traders, for example, by highlighting whether a trader is trustworthy on their profile. This can be achieved by integrating buyer and seller reviews, which then allows traders to guess the trustworthiness of a particular buyer or seller. Yet, it remains relatively easy to deceive prospective buyers with fake reviews.
Even though deploying marketplaces under centralized control is a standard approach, some of these markets have gained significant market share and have acquired a monopoly position. This opens the door for market operators to manipulate the market environment, exploiting their authority to deceive and nudge platform participants. For example, a marketplace like Amazon can decide to present different prices for the same product to different users, a concept known as price discrimination. Another example that shows the scope of this threat is the ongoing legal battle of Apple vs Epic Games, where Apple is being accused of anti-competitive behaviour with their App Store market by prioritising or hiding particular search results. This gives an unfair advantage to the apps offered by the market operator since they are more prominently visible. Such manipulation practices are, in general, challenging to detect since the market software at the server side is usually proprietary.
Decentralizing and Disintermediating Markets with Blockchain Technology
The influence of trusted authorities is also apparent beyond electronic marketplaces. For example, “Big Tech” companies such as Facebook, Twitter, and Apple have accumulated so much market share that they are capable of acting as small states that are inhabited by billions of virtual users. This concerning development has increased the popularity of blockchain technology. First described in the whitepaper of Bitcoin, blockchain technology can reduce or even remove the role of trusted third parties. Instead, blockchain enables users or businesses to conduct business without any trusted third party like a bank or a notary. All transactions are securely stored in a distributed ledger, and transactions are irreversible once included. End-users themselves maintain this ledger, and invalid transactions are automatically rejected. Since a full technical description of blockchain technology is beyond the scope of this post, we refer the reader interested in knowing more about the technical workings of blockchain to this article.
Blockchain technology can be applied to decentralize and disintermediate electronic marketplaces. Before explaining these concepts, we emphasise that electronic marketplaces consist of different aspects (we will write more about these aspects in a separate blog post). The process of decentralization and disintermediation can apply to all these aspects. These aspects include but are not limited to information management, payment processing, and fraud management. For example, the IDEX cryptocurrency exchange uses blockchain technology to exchange assets without centralized authority but at the same time uses a single server to match buy and sell orders.
Decentralization is often defined as delegating authority from a single operator to end users instead. In the context of electronic marketplaces, this means that the authority of the market operator is reduced or even removed. For example, instead of having the market operator handling a payment during a trade, this payment proceeds directly between users (e.g., using cryptocurrencies) without coordination by the market operator. Decentralization can also mean that market information is stored and managed by users themselves instead of being stored on the servers of the market operator. From a technical perspective, decentralized systems can be challenging to build since all communication and interactions are directly connected. There is no central point of coordination anymore. Decentralizing a marketplace also introduces new risks. For example, malicious users can attempt to manipulate the system and attempt fraud. The market protocol should be resistant against such users, e.g., by identifying bad behaviour and kicking these users out of the network. Still, this is much harder to achieve without centralized supervision.
Disintermediation is the process of reducing or removing the role of trusted third parties involved in an interaction. The rise of the Internet encouraged disintermediation in various supply chains and made various traditional brokers redundant. Instead of relying on brokers for market information, traders can use the Internet to browse the market catalogue directly and connect with other traders. Disintermediation is closely related to the concept of decentralization since both concepts delegate authority back to end-users. A key benefit of disintermediation is the potential to reduce transaction costs since intermediaries often charge fees for their services. Airbnb, for example, charges hosts 20% service fees when participating on their platform. These costs can be avoided when hosts and guests would interact directly without the involvement of Airbnb.
Blockchain technology is capable of taking on the responsibilities of a central market operator. Many blockchain platforms allow developers to write contractual logic in the form of smart contracts. This code is then fully executed on the distributed ledger without supervision by a trusted party. Smart contracts can encode the necessary market logic to exchange assets between traders.
Now that we have discussed the concepts of decentralization and disintermediation, we look at different blockchain-based marketplaces. We first define a blockchain-based marketplace as an electronic marketplace that leverages blockchain technology to carry out one or more of its critical operations.
The original vision of Bitcoin is to provide a peer-to-peer cryptocurrency for merchant payments. After Bitcoin gained traction, there have been many proposals for alternative cryptocurrencies with different design decisions. At the time of writing, there are over 10 000 different cryptocurrencies, according to Coinmarketcap. The rapid increase in cryptocurrencies motivated the deployment of digital exchanges where traders can quickly trade one coin for another. Popular cryptocurrency exchanges are Binance, Coinbase, and Kraken. These platforms handle trade worth billions daily and are a gateway for many people who wish to enter the world of blockchain and cryptocurrencies.
Even though cryptocurrency exchanges enable the trade of many cryptocurrencies, most of these exchanges are operated by a single authority. These market operators act as trusted intermediaries since they require traders to entrust their assets with their wallets. This conflicts with the nature of blockchain, which is to build open ecosystems that put users themselves in full control. Additionally, central storage of assets poses a major risk since the market operator is expected not to default and release ownership of the users’ tokens when they wish to withdraw their assets. The events surrounding the Mt. Gox exchange in 2014, during which hackers stole assets worth around $450 million, shows that centralized cryptocurrency exchanges cannot always be trusted with user funds.
Decentralized Exchanges (DEXes)
Decentralized exchanges, or DEXes, are marketplaces that fully run on a blockchain ledger. DEXes are usually asset markets where users can exchange custom assets by creating, managing, and fulfilling orders on the blockchain by issuing transactions. Some blockchains, such as BitShares and Stellar, support asset creation and exchange at the protocol level and include specialized transactions to manage and trade assets stored on that blockchain. Other platforms, such as Ethereum, allow developers to implement the necessary market logic, e.g., by using smart contracts.
Trading on a DEX is more secure than on a centralized exchange since trade is often atomic: all assets between two parties are exchanged, or none are. This means that no party is left with a net gain or loss when the trade is completed. Furthermore, DEXes avoid centralized control, making them more robust against large-scale asset theft, manipulation, and censorship. Unfortunately, trading on DEXes can be expensive to do in bulk since users have to pay fees to issue transactions that create or update a particular order. Furthermore, the scalability of a DEX depends on the technicalities of the underlying blockchain and is in practice limited to around 1 000 transactions per second at best. This is by far not sufficient to handle the transaction volume that major marketplaces have to deal with. Finally, most DEXes only support the exchange of assets that reside within the same blockchain ecosystem.
Recently, Decentralized Finance (DeFi) has gained significant popularity. DeFi is an experimental form of finance and consists of a large ecosystem of decentralized applications for managing blockchain assets. Marketplaces are a major part of DeFi. Uniswap is a major player in this area, with a daily trading volume of almost a billion USD.
Other blockchain-based Marketplaces
Cryptocurrency exchanges and DEXes are positioned at two ends of a spectrum in terms of decentralization. There are also various solutions that decentralize only particular aspects of electronic marketplaces with blockchain technology. We highlight two of these solutions. OpenBazaar is a peer-to-peer marketplace protocol built on top of the decentralized IPFS network and uses cryptocurrency payments. It uses a reputation mechanism to flag suspicious users. Bisq is a blockchain-based marketplace that supports the exchange of Bitcoin for fiat currency. Assets are exchanged manually between users. The marketplace aims to prevent fraud by using multi-signature transactions and human intervention when a conflict during a trade arises.
As more business moves to the digital realm, the scale of electronic marketplaces is likely to keep expanding. In this post, we have described how blockchain technology has the potential to reshape traditional marketplaces that are under the control of a single authority by the decentralization and disintermediation of existing market processes. This makes electronic markets more secure against manipulation, fraud, and censorship. While it is unlikely that traditional, centralized marketplaces are fully replaced by blockchain technology, we believe that there are many promising developments that can lead to more fair marketplaces.