How to Build Marketplaces & Why Many Will Be Decentralized

Why do marketplaces exist?

Marketplaces exist because they are an improvement over the alternative. If you can imagine, the alternative would be salesmen yelling aimlessly for buyers, and buyers potentially doing the same as they look for viable sellers. Whether in person or online, this situation would quickly devolve into chaos with buyers and sellers indiscriminately yelling for each other.

As an improvement over this chaos, marketplaces naturally form around large buyers and sellers of distinct goods and services. This generally happens because the larger buyers and sellers soon form reputations as such, and participants on the other end know that they can find their good, service, or buyer in one place. Other buyers and sellers who have not built their reputation as powerful participants can tag along with those who have and will benefit from the uptick in traffic and interest that the bigger buyers and sellers receive.

Why do participants pay fees?

Sellers pay fees because it’s cheaper for them to pay to access a large pool of buyers than it would be for them to hire salespeople to go find them individually. Buyers pay fees (though possibly indirectly) because it’s cheaper to pay the fee than it is to find and vet individual sellers they can trust.

Why do marketplaces charge fees?

Marketplaces charge fees because they can. The business school answer might go something along the lines of marketplaces charge fees to recoup the risk shareholders took to invest in the establishment of the marketplace and to fund the continued protection of marketplace participants. While this more verbose explanation is true, it’s probably better to remember the level of fees basically takes into account:

a) how valuable the marketplace is to the participants,

b) how many other options they have for exchanging their goods and services, and

c) the switching costs participants must undertake to move their good or service to a new platform.

Internet marketplaces V1

If we can put ourselves back into our 1997 mindsets (for readers under the legal drinking age, please forgive me), we can remember how scary it was to fathom buying something on the internet. Who is on the other end? Will they steal my personal information? Will I even get what I paid for? were all common and reasonable questions at the time. Internet bears were not wrong for identifying these risks. They were wrong for mispredicting the profitability and technical feasibility of minimizing these risks.

With the emergence of PayPal, buyers could feel some degree of comfort surrounding the latter two fears, and it turned out that the buyers don’t care too much who is on the other end, so long as they are honest. Marketplaces like eBay, Amazon, and StubHub popped up in Web 1.0 and were followed by more unique offerings like Uber and Airbnb in Web 2.0.

Marketplace life cycles

Profit-seeking marketplaces will go through multiple phases during their life cycle. In the beginning, they’ll be everyone’s best friend. Because when they’re new, they need to make a good first impression; they’ll even be willing to subsidize buyers and sellers joining the platform, effectively lessening the switching costs both buyers and sellers must incur to learn a new system.

Once a new marketplace gets a core set of buyers and sellers, they’ll realize that they weren’t the only kids in town with the idea and a competition will occur. Because buyers usually get the lowest prices through marketplaces with the most sellers, and sellers usually get the best offers through marketplaces with the most buyers – an arms race occurs for market supremacy. Your marketplace will either grow or it will perish.

During this arms race, firms will go to extreme ends to kill their competition. The best-capitalized firms will survive because they can offer their buyers the steepest discount. Sellers may continue to get wooed if they can easily switch platforms, but if the switching costs for sellers is high enough, they’ll keep all or most of their goods or services available through just one platform regardless of how poorly they are treated. Profit-seeking marketplaces understand these dynamics and will shape their incentives in such a way that lure participants into corners they can’t easily escape.

Sure new competition can step up, but it will generally need to focus on niche offerings that aren’t well supported by the more dominant marketplace. If new entrants try to compete head-on with the incumbent monopolists, they can expect to be boxed out via price dumping.

When the baton will be passed

The baton will be passed from centralized marketplaces to decentralized marketplaces when decentralized marketplaces can offer better value for their users. This seems obvious enough, but it’s important to remember this will be a sequential occurrence, not an avalanche. The first set of use cases will likely be from people exchanging goods and services that carry a social stigma high enough for larger, centrally controlled marketplaces to want to avoid it. So if a woman wants to obtain birth control but believes the process of obtaining a doctor’s prescription to be too invasive, a decentralized marketplace could fill that need. Or if she wants to buy highly personal products without the fear of being retargeted, a decentralized marketplace could fill that need. Because the costs of switching marketplaces can be relatively high, it’s likely that the first use cases will exist not because they’re better than the alternative – they’ll exist because there is no alternative.

As governments and social police become more restrictive about what we can and should buy and as AI tools improve how well companies can infer highly personal user information, you can expect more marketplace participants to incur the time cost of switching marketplaces to avoid the hassles and limitations of the existing marketplaces.

Once this critical mass of users is established, they’ll actually be the first segment to also realize that eliminating the restrictions of a middleman also means eliminating his fees. In addition to using the marketplace for new goods and services, these initial users will tell their friends about these new marketplaces where they can save 10% or more over existing marketplaces. And depending on the token economics of each decentralized exchange, token-holding first users could actually profit from their evangelism.

For the baton to pass, the marketplaces themselves need to be developed while security and identity solutions are put in place to ensure a sufficient level of trust and transparency exists for transactions to occur.

What does this mean for the future?

All centralized marketplaces aren’t going to completely die off because of blockchain technology. What’s more likely to happen is there will soon be a wider range of user choices and for some users and use cases, a decentralized solution will prove to be superior. And the next several years will make up the fun part when we can build what doesn’t exist and fix what’s broken along the way as we search for the users and use cases where decentralization will have its largest impact.