Wacky, But Serious: What would it take to set up a stock market?

I was part of a project about a few years ago to do such a thing. The algorithms for writing a stock exchange are quite well known. I was just working on the interface, so I don't have a complete understanding of what was going on under the hood, but it was my understanding that we were using the same algorithm as the London Stock Exchange, which was developed using public funds and hence was made available to the public.

The most difficult thing to do in getting a stock exchange off the ground is not developing the software, but developing trust and liquidity. To do this, you need market makers - people who are obligated to provide buy and sell orders that keep the markets liquid. This is very very expensive.

We actually had an operating stock and commodities market, where you could trade the world's top currencies, gold, silver, platinum - for about 6 months, then 9/11 hit and it became very difficult to maintain the kinds of banking operations necessary to run an underground stock exchange.

Hrm, liquidity is certainly a factor. What if you simplified things though? Take the focus off of trading and put it into the investment aspect? I suppose there would be something to be said about the obligation of the startup to actually be held to pay up though.

A stock market is set up to trade fungible bits of paper that have been contractually linked to companies (securities), commodities (futures), or derivatives like options. The algorithms for pricing and linking up buyers and sellers of these fungible bits of are fairly straightfoward.

The types of contracts involved in initial investment in an idea or company aren't fungible, and tend to be highly customized affairs between the VC, the founders, and their lawyers.

In other words, the algorithms (and interfaces (and laws?)) for scalable venture investment are immature, meaning it's still in the domain of trained professionals, like using software before GUIs.

It's purely the laws that force that.

> The algorithms for pricing and linking up buyers and sellers of these fungible bits of are fairly straightfoward.

Yes, but maintaining liquidity in a dynamic environment probably requires market makers, no? I don't think there's an algorithmic solution. You need the specialists.

Mind linking to some of the underlying stock exchange algorithms?

It's not really an algorithm. It's called a limit order book. At least that's the way many electronic markets work.

Yeah, it's pretty trivial. Here's a quick implementation description in CS terms:

1.) Keep two heaps, a min-heap for sellers and a max-heap for buyers. The top of the seller heap is the "ask price". The top of the buyer is the "bid price". The difference between them is the "bid/ask spread".

2.a.) When a limit order comes in, put it in the appropriate heap. Then compare the tops of the heaps. If the prices overlap, send a fill message to the parties. Pay attention to quantities; you may have to send a partial fill to one party and a fill to another, and then repeat the process with the next order in the order book.

2.b.) When a market order comes in, immediately pop the top of the opposing heap and send out the appropriate fill or partial fill message.

That's basically it. Depending on language, you're looking at anywhere from a page to a few hundred lines of code. An actual stock exchange is a bit more complicated, since it has to handle things like order cancellations, cancel-pending messages, transaction logs, and fault-tolerance, and has to operate on thousands of trades a second with minimal latency. But conceptually, it's simple.

(And if Joshua corrects any of this, listen to him and not me. He was an actual quant; I just worked at a financial software startup.)

I guess it's more of a "data structure" than an algorithm. Anyway, you need more than a heap, because price, time, size all matter. That's pretty close, though.

Many exchanges are well documented, from internal workings to protocols. Check out XETRA, LSE, etc. NASDAQ too, but it's more complicated.

The problem here is going to be achieving regulatory compliance and then liquidity. Both of these are harder.

would this be useful?

http://sourceforge.net/projects/fse/

You fall under their regulation if you're in the US. http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Co...

Good luck.

Are things like Intrade regulated?

yes.

Intrade doesn't sell stock. It sells betting contracts. It's an entirely different type of regulation, and is actually illegal here.

It is? Oops.

Illegal to run. Not illegal to play at (probably).

I should amend that. Not illegal to play at in most states.

Intrade offers futures contracts on various events. It's not betting per se and they can be used as part of a legitimate investment portfolio.

It's still illegal here though, the US government will find a way to shut down any kind of innovative online market.

It's not equity, and unlike futures, there's no underlying asset so it's not analogous to stocks, options, futures, or anything the SEC regulates. It's just a different type of gambling.

Couldn't you use betting contracts to implement a kind of stock market? You could certainly use them to implement most kinds of derivatives.

What about a non-equity market to finance businesses? Instead of selling equity shares, you are paying money to a company (and a broker) for the opportunity to bet that company will achieve a certain level of income in a certain period? You'd be able to bet both with and against that company. The former would be equivalent to bonds.

Intrade is based in Dublin. The Iowa Electronic Market has a special no-action letter from the Commodity Futures Trading Commission.

There are dark pools (http://en.wikipedia.org/wiki/Dark_pools) that are under far less regulation at least ....

If it were a private equity market, there would be no regulation.

This is not all that crazy.

To be perfectly honest, reading this was quite a shock, though. This is (loosely) the idea I have outlined for RailsRumble 08, coming up this weekend. Ours will not (at first) involve exchange of real money, but the concept will be the same: 'Normal' people will be able to choose startups they find promising and invest in them.

Haha, well... maybe you're onto something then. Good luck to you!

Thanks! I've definitely got some technicalities to figure out before Friday.

My biggest issue is that it seems so obvious that there's got to be something fundamentally flawed with the idea. At first I thought it might be illegal, but I'm not seeing how that could be.

Let us hope for my sake that it is not illegal :)

I would definitely check with a lawyer before doing something like this.

There're certain situations where you need to be an "accredited investor" (liquid net worth > $1M) to take money from the public. I know hedge funds are one of these; I think private companies are another. If a private company has more than a certain number of shareholders, they need to file disclosures as if they were a public company; this is why Google went public. These protections were put in place after the crash of 29, when a great many ordinary investors lost their money investing in companies that weren't much more than a piece of paper.

Again, talk to a lawyer. This is one area you don't want to dick around in without good legal advice.

Good advice, but what about Kiva.org? Don't they essentially act in the same way? Granted, there is no real return offered.

I'm not a lawyer and hence not qualified to give legal advice. I can only speculate (always a dangerous thing)...

I'm guessing that it has everything to do with a real return not being guaranteed. Same goes for Prosper.com and MicroPledge. Anyone can raise money for anything on the Internet: folks do whip-rounds via Paypal to buy friends a new laptop. But if you want the legal guarantees of stock ownership, etc, you need to file the appropriate disclosures.

</not-legal-advice>

Heh, this is pretty interesting:

http://www.prosper.com/help/topics/lender-quiet_period.aspx

You're right, lenders on Kiva aren't paid interest. Kiva's founders have said this is so they don't have to comply with burdensome investment legislation.

Lenders to Kiva also aren't buying securities -- they're providing money to a microfinance institution which then distributes the money as promised, hopefully to return it later. Should the loan not be repaid, the lender has no rights to any assets.

There're certain situations where you need to be an "accredited investor" (liquid net worth > $1M) to take money from the public. I know hedge funds are one of these

You need to be an accredited investor to put money into a hedge fund.

Anyway, what the world really needs is not a new stock market but rather a new banking system.

You really don't want to mess around with this without consulting a lawyer first. A misstep could mean committing multiple felonies and possible jail time.

Seriously, talk to a lawyer.

Right, hence my saying that it will be ficticious in its initial incarnation.

As long as you're not taking in real money or paying out real prizes, you're OK. It is actually illegal in some states to pay out real prizes even if the entry is free due to sweepstakes laws, and there you get into the 'consult your laywer' area. But even then, the odds of anyone ever prosecuting you for giving stuff away are virtually non-existent.

Never talk to a lawyer until money is about to change hands. More good ideas are killed, deformed or outright stolen by lawyers than by any other means...ever.

I don't think it's a crazy idea but, as rms pointed out, if you publicly announce part of your company for sale, you fall under SEC regulations.

What might be a better idea is to let people put small amounts of money into a fund. Then, let startups apply and the fund members could vote on winners ... sort of YC-style.

For all I know that could fall under SEC regs too.

Nope, you can do this. Brian Singerman and I did it. But it's a boatload of work. We did it once, and I'm pretty sure we won't do it again, at least not any time soon.

I tried to do something like this once. If you were to try in the USA, here's what I might tell you:

The regulatory burden is immense. This is a project for lawyers. However, keeping ordinary investors away from your exchange would help a lot. Open it to accredited investors only. This would make the regulatory environment much simpler.

You would be competing against established competitors, like the Toronto Venture Exchange, on which are traded companies with a market cap of a few million dollars. An IPO for a company to be traded on the TVE is a lot like a series A in the USA.

Keep in mind that you are talking about three functions: 1) turning the stock of a company into something that can be bought and sold by the public 2) distributing that stock to its initial buyers 3) giving that stock a place to be bought and sold

The first two are done by investment banks, who normally do the work of preparing the stock of the company to be traded on NASDAQ as well. Only the last function is what an exchange does. #2 is what W.R. Hambrect has been trying to improve with his OpenIPO (see link below).

Generally in small market cap companies the job of a "market maker" is thought to be essential. I don't buy this. I think an exchange without much liquidity is better than nothing.

Start reading here:

http://en.wikipedia.org/wiki/OpenIPO

http://en.wikipedia.org/wiki/Electronic_Communication_Networ...

http://en.wikipedia.org/wiki/Arizona_Stock_Exchange

http://en.wikipedia.org/wiki/Over-the-counter_(finance)

I'm not a lawyer and this is not legal advice. Get a lawyer.

As everyone's pointing out, any exchange for trading securities falls under massive amounts of regulation. It's possible to navigate the legal morass, but will require a group of lawyers with vast experience in securities law and regulations, preferably at the international level as well.

New exchanges have been created by private companies in the past, although typically (AFAIK) with large infusions of cash from major banks. IntercontinentalExchange (http://en.wikipedia.org/wiki/IntercontinentalExchange, http://www.theice.com) is an example, although it focuses on commodities, rather than stocks.

It happens all the time. Usually a consortium of banks who trade a lot with each other decide it's going to be easier to set up a separate organization to handle all their interactions. I worked on one a few years ago, Centradia, which was a private exchange that 5 banks used to pool liquidity for foreign exchange dealing. Thera are quite a few, and no-one outside the industry will ever have heard of them. A mate of mine's at Equiduct now.

Well, if I accept money from my uncle with the understanding that I'll pay him back ten fold if I make it big, that's legal right? And let's say I get five friends and make the same deal with them; again, nothing illegal there right?

Where exactly is the line drawn here...

Well, if I accept money from my uncle with the understanding that I'll pay him back ten fold if I make it big, that's legal right? And let's say I get five friends and make the same deal with them; again, nothing illegal there right?

Unfortunately, induction only works in mathematics, not in the legal system. I'm sure there's an arbitrary line somewhere, and that that line has to do with "intent". (Getting 10 friends to invest, probably fine. Getting 10 people responding to a newspaper ad, probably not fine. Ah, the legal system...)

Getting 10 people responding to a newspaper ad, probably not fine.

There's two reasons why this isn't fine, actually: You can't get strangers to invest unless they're accredited investors; but also the newspaper ad itself is illegal ("public offering of an unregistered security" or something along those lines).

My post is about induction. Let me explain in detail:

It's OK for one person to invest in my startup.

It's still OK if I get one more person to invest in my startup. Induct on the number of people.

It's OK to get an infinite number of people to invest in my startup.

Q.E.D.

The reason induction doesn't work is because the law defines that a certain number of people is "public offering of an unregistered security". In math, there is no such restriction.

Where exactly is the line drawn here...

It varies by jurisdiction, but usually the rule is that "friends and family" are ok, but you can only take money from strangers if they're rich (i.e. "accredited investors"). In BC the "friends and families" rule is defined more or less as "people who have direct knowledge of you and are investing in you instead of the company".

But again, the rules vary by jurisdiction -- so consult a lawyer who is familiar with the rules in your jurisdiction before you do this.

There are two lines:

1. Public solicitations is a no-no. What constitues "public" is quite well-defined.

2. Investors must be able to fend for themsleves - either be educted in the area, rich enough to hire someone who is or otherwise be able to assess risk.

I think a good place to start looking for a model is donorschoose.org. Don't invest in companies: invest in projects. If you broke the company up into small, discrete, chunks you could probably get under the investor limits and not have to file a disclosure. You would basically be letting the market allocate funds within a firm.Then, the firm just breaks up profits and gives dividends. Of course, the term "firm" doesn't really fit here, things would be much looser than what fits into our present definition.

You would still need a crazy team of lawyers to avoid trouble, but it's certainly a loophole worth looking into and a very efficient system for allocating capital.

There are venture markets for smaller companies. Such as those in Vancouver, Canada. But the stocks are so volatile it scares off most investors.

I once saw this, it could be what you are talking about, kind of: http://couchtycoon.net/

Another approach might be to create a service that helps startups open their books to become financially transparent. With Amazon FPS, not only could you expose sales data in real time but you could split the revenues among individual stakeholders. So the idea is, raise capital by encouraging your visitors to purchase a share of your future sales - and make the algorithm so transparent that they're assured X even if Y happens.

Your main problem will be liquidity - you'll have to find people who care enough to throw in some money.

Maybe you could start by setting up something like http://intrade.com. First you just let people bet on whether a company would succeed or not by some metric. If you get enough people interested and knowledgeable about the companies you're dealing with, maybe you could lead that into funding.

The FOREX (Foreign Exchange) market is pretty much the wild west of trading at the moment. No central exchange, little to no regulation, etc...

On average you'll need around 400K to buy a trading server (Meta Trader, ActForex, Manhattan Platform, etc), market the brokerage, and setup relationships with liquidity providers.

Not exactly a stock market, but its the closest to a tangible trading business for someone looking to get into that type of market.

"What I need is a market that allows me to invest little bits of money into new ventures."...I would also like it.

So here is my shot at it.

1.- Set up a fund where you can buy shares.

2.- Invite start-ups to apply for our fund.

3.- The shareholders of the fund get to vote.

4.- The fund invests money in the chosen start-ups.

5.- The share holders (as individuals) try to help the start-ups (testing, word-of-mouth, ideas, etc.) It will be more like VC 2.0 ;-)

Edit: formatting.

What's the point of owning your own stock market?

Folks won't buy on your market if prices are lower elsewhere. Folks won't sell on your market if prices are higher elsewhere. Yes, there will be momentary discrepancies, but DE Shaw will drive them to 0.

I think it's a great idea ( I've had the same one :-)) The problem, of course, is the legality of it, though perhaps there could be ways around it ( an offshore market? structure it as a mutual fund? ). You'd need a great lawyer ...

You might have to be an accredited investor in order to do these sort of investments.

There does, however, need to be a niche market between VC and IPO where early investors could get a much easier exit.

Edit: you also need a ton of capital coming in so it can be liquid.

Ideas that are initially wacky often seem brilliant in retrospect. I like it a lot.

Putting the investment into the hands of hackers who understand the technology better than anyone else...

Makes me wonder if we would even need VCs at that point anymore.

Also remember that "normal" stock markets are secondary markets, buying a stock doesn't actually provide capital to the startup (unless it's the IPO).

Good point, but it could still be helpful. If you are a VC, it is probably nice to know you can inject some cash into a company and if the company starts going downhill, you can easily sell your shares to someone else.

At the same time, Joe Average might be able to pick up some "deals" on startups that VCs think will fail but he thinks will do fine.

The market is not a bad idea.

Think microfinance. I'd love to join that revolution.

Microfinance tends to be concerned with micro-loans, which would be more akin to bonds. The topic here is equity, which is partial ownership of companies and other enterprises.

"tends to be concerned with micro-loans"

Last year there was a very convincing video on Ted about Africa needing basic financial infrastructure like a futures market.

I've read other people about "Joe The Plumber" not having access to futures to protect large financial operations like purchasing real estate.

Also Nasdaq, NY, etc. are completely unaffordable for small ventures (perhaps why most people on dotcoms aim at multimillion sized IPOs.)

This has to change.

The US also has strict rules against gambling, and stock markets are very borderline -- so watch out!

see http://vencorps.com

Never quote Einstein. It generally has the opposite effect of what you intend.

What I'd like you to do is to think about the effect you intended to create by quoting Einstein. Then constrast this with the effect that would have been created had you quoted someone obscure.

Not including the oldest commercial corporation in North America, The Hudson Bay Company is a bit weak.

http://en.wikipedia.org/wiki/Hudson_Bay_Company

wrong thread dude.

So, like, a free market of free markets?

It'd probably be an auction, too. You could easily use Ebay, except for regulation.

Bid/Ask is a much more efficient system than an auction. Stock markets were all English auctions until people realized there was a better way.

You might want to look at private trading markets. It is sort of a lower scale version of the public markets. Companies can be traded between entities as stock without the onerous accounting requirements but there are certain stringent requirements. There can be at most 400 share-holders and the deal killer -- stock holders have to be institutional investors with over $100 million in assets. If you have that much cash, you may as well become a VC.

I am not an expert on this so independent checking on this would be nice. To my knowledge, NYSE and GS have setup something like this.