Blockchain 1: An MFRM DeFi Primer for 2023

Blockchain and Decentralized Finance:
2024 Intro for MFRM

Presenter: Andreas Park

Agenda

Background:
- Vocabulary & Evolution
- What's DeFi and what's different to TradFi?
- Explain some key DeFi applications
- What do we know about tokens?
Getting your hands dirty!

Some Technological Innovations throughout History

technological innovation removes barriers:

what can be done
how much can be done
by whom it can be done

many innovations move power to do things from selected few to the masses

tech disrupts a group of people who built a living around a technological restriction and they disrupt government power exerted via these groups

technological innovation removes barriers:

what can be done
how much can be done
by whom it can be done

What is a Blockchain?

What is a Cryptocurrency?

Conceptually, what is a blockchain?

What our financial infrastructure looks like

payments

stocks, bonds, and options

swaps, CDS, MBS, CDOs

insurance contracts

payments

stocks, bonds, and options

swaps, CDS, MBS, CDOs

insurance contracts

$\Rightarrow$ a single common resource

easy value management
straightforward transfers & ownership accounting
new types of contracts and usage of assets
$\ldots$

What would the most efficient financial infrastructure look like?

$\approx$ 50% is bitcoin (but used to be 70%)

How do you own a blockchain asset? Addresses, Accounts, Wallets, and Public/Private Keys

Smart contract accounts

controlled by code
decentralized applications
tokens

Externally owned accounts

controlled by private keys

private
key

public
key

seed phrase

public
address

wallet = software to keep and use private keys

Self-custody of assets
Access to financial infrastructure
Value management layer = common resource
Platform approach to commerce

What makes blockchain-based finance different from TradFi?

What makes DeFi different from TradFi

decentralized finance =
provision of financial service functionality without the necessary involvement of a traditional financial intermediary like a bank or broker-dealer*

digital media =
provision of information service functionality without the necessary involvement of a traditional information intermediary like a publisher, library, or newagency

*my take: applies to only commoditizable services

trading Infrastructure

payments network

Stock Exchange

Clearing House

custodian

beneficial ownership record

seller

buyer

Broker

Application: decentralized trading with automated market makers

Application: Decentralized Borrowing & Lending

borrow

provide collateral

5. repay DAI

for loan
with health factor <1

liquidation
opportunity

1. flash-borrow DAI

2. repay loan
with DAI

3. claim
collateral ETH

4. convert ETH to DAI

Some Data

Obvious Smart Contract Application: Automate Investment Strategies

idea: create new mutual fund like asset

"yield aggregator:" push capital where rate of return is highest

What roles do tokens play?

People clearly treat tokens and cryptocurrencies as objects of speculation

data: authors calculations from TAQ (up to March 2023)
crypto volume worldwide is larger by factor >4

Self-custody of assets
Access to financial infrastructure
Value management layer = common resource
Platform approach to commerce

What roles do tokens play?

recall the differences

$\to$ key feature: no necessary intermediaries

Application 1: decentralized trading with automated market makers

Problems:

How to get liquidity?
How do you attract traders?

lesser problem because

tokens trade elsewhere
arbitrage creates activity

Common solution: create a reward token! Here's how this works

Step 4: users receive a reward token based on the time that they lock up the "receipt" token

Step 3: users lock up the "receipt" token in a smart contract

Step 2: users contribute liquidity and get a "receipt" token

Step 1: create reward tokens and deposit into a smart contract

borrow

provide collateral

Application: Pool-based borrowing and lending

Application 2: decentralized Borrowing and Lending

Same problems as with trading:

How to get liquidity?
How do you attract borrowers?

But: in contrast to trading, here you need both!

liquidity $\nearrow$

volume $\nearrow$

protocol fees $\nearrow$

token value $\nearrow$

Platform economics is tricky:

What's the product?
How do you get it started?
How do you get people to contribute?
How do you earn money?

Without intermediaries:
platform economics!

incentives for both?

Asset Tokenization or
"The Creation of Asset-Linked Tokens"

Tokenization is coming

this list contains mostly "neglected" assets
what about very "busy" assets aka equities
- what challenges apply to tokenization?
- what problem are you trying to solve vis-a-vis traditional markets?
- what do we have to worry about with a defi implementation?
- what are the opportunities?

Challenges

Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/

Challenge 1: Energy Consumption

Ethereum Challenge 1: Environment

Carbon footprint of Switzerland
Power consumption of Austria

problem solved

	transactions per second	T per 12 hours (business day)
Bitcoin	7	302,400
Ethereum	30	1,296,000
Algorand	2000	86,400,000
Conflux	4000	172,800,000
Athereum	5000	216,000,000
Payments Canada ACSS	648	28,000,000
US retail	7639	330,000,000
Canada number of equity trades	46	2,000,000
Orders on Canadian equity markets	3588	155,000,000

Tweaks: lighting network (BTC) or side chains, SegWit, blocksize possible, but there are limits
microtransactions, IoT, and other smart contract use cases place very high demands

Ethereum Challenge 2: Throughput

Source: Etherscan w re-scaling

Ethereum Throughput Solution: L2s/Rollups

Ethereum Challenge 3: State Size

Source: Ycharts

Money Laundering and Crime

Chainalysis Crime Report

extra info:

2019: PlusToken Ponzi scheme
numbers depend on known addresses, e.g., 2021 report listed ~.3% for 2020 and upped to .65 now

Banned addresses

criminals don't use USDC - why are we so worried?

Hacks, Thefts, and Exploits

Common Reasons: hacks, faulty code, tricking a protocol

Miner extractable value and High Priority Gas Auctions

What is a stablecoin?

digital representation of a unit of a fiat currency on a blockchain

pulled from Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"

Collateral Backed Stablecoins: USDT & USDC

$\Rightarrow$ 5% over-collateralized

primary market acces: 6 entities only

Collateral Backed Stablecoins: USDT & USDC

"Cash at Reserve Banks" once was SVB
Reserve fund = short-date US treasuries & overnight repos

primary market acces: 560+ entities

What makes a Stablecoin stable?

USD-USDT (6 months)

$\Rightarrow$ need a primary/reference market mechanism to allow for forces of arbitrage to align prices

stablecoins are issued
- by a single entity or
- a blockchain-based algorithm (smart contract)

they trade in a secondary market
- on crypto-exchanges against fiat
- on crypto-exchanges against cryptos
- on-chain against other tokens
$\Rightarrow$ stablecoin price fluctuates

Stablecoin use cases

What do central bankers think about stablecoins?

BIS Survey of Central Banks:

Source: On-chain Foreign Exchange and Cross-border Payments by Austin Adams, Mary-Catherine Lader, Gordon Liao, David Puth, Xin Wan (2023) [team from UniSwap Labs]

DeFi fees:

fiat to crypto on ramp: 0%-1%
exchange fees 1-5bps
network fee: $0.001-5$
off-ramp fee: 0%-1%
total: from close to 0 to 2%+$5

Central Bank-Issued Digital Currencies

Evolution

2008

2014/5

2019

2020

The Year is 2008: what the Toronto a la cart program teaches us about CBDCs

Cautionary tales for central bank innovation

Finland:
- Avant card failed
China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
Mexico:
- QR code pay uptake <5%
  (not CBDC)

what people want

what we got

a program designed by city departments
no regard for business owners or customers
burdensome regulation
a truck ("cart") designed by committee that did not work
program essentially died after 2 years

Features of Digital Money

instantaneous 24/7 payments
digital = borderless
money that is compatible with digital applications, digital finance, internet of things etc
privacy protection
peer to peer transfers
transfers of money without the involvement of a commercially interested third party
non-fee digital payments

fast money

CBDC run by
Central Bank

CBDC on new communually run system

bank-issued stablecoin on public blockchain

What?
24/7 instantaneous
borderless
programmable
privacy
p2p
no commercial 3rd party
nominal fee

Why are Blockchains challenging for current regulation?

What is blockchain=crypto? Some basic facts

anyone can use it

a open, general-purpose
digital value management tool
that maintains digital scarcity

ownership & control is direct and not intermediated

it's a protocol, not a thing

it does not belong to anyone

practically impossible to prevent the creation of code

borderless and digital

does not require high tech, a laptop is enough

requires use of tokens

What is blockchain=crypto? Some basic facts

anyone can use it

a open, general-purpose
digital value management tool
that maintains digital scarcity

ownership & control is direct and not intermediated

it's a protocol, not a thing

it does not belong to anyone

practically impossible to prevent the creation of code

borderless and digital

does not require high tech, a laptop is enough

requires use of tokens

The Investment Process

issuers

investors

funding
record-keeping
instruments

custody
advice
trading

services
needed & provided

takes care of custody and allows self-custody
allows instrument creation
enables record-keeping
allows circumvention of existing institutions

A general purpose value management infrastructure:

intermediaries

separate institutions

asset custodians
broker-dealers
trading platforms

The blockchain reality:
new institutions
emerged that do all three

tokens are often not intended to be investments!

... and that brought us ...

wash trading
pump-and-dump schemes
Bitfinex-Tether price manipulations
cyber hacks
epic thefts, "rug pulls," and fraud

crypto trading platforms and custody risk

subtle changes in rules to make holding and using crypto illegal/impossible
regulation by enforcement actions
"almost all crypto-assets are securities"
rushes to pre-empt Congress

Regulators' Focus

MiCA

whitepaper rule
platforms as money services businesses

What is a security and why does it matter?

simple view: investment contract
traditional view/test: Howey/Pacific Coin
- investment of money
- in a common enterprise
- with reasonable expectation of profits
- derived from the efforts of others

"What's the big deal $\to$ just download a form from our website and register!"

latest S.E.C. view: security =
- investment of money by small investors
- small group of people work on bettering the "eco-system"
- and avertise betterment and advances

$\Rightarrow$ people (may) buy token with investment motive

$\Rightarrow$ require protection from securities law

What is a security and why does it matter?

TS is a business enterprise
many people buy TS tickets
with clear expectation of profit
based on the efforts of TS and her team
and trade them in a public market

people buy Aeroplan cards and points
with the expectation to benefit of them in the future
hoping that Aeroplan provides a useful service in the future

Problem 1: many tokens as securities become untradeable and lose their use value
Problem 2: issuer compliance with self-custody is almost impossible
$\Rightarrow$ it is impossible to balance investor protection and user needs with the current U.S. tools

So what's the problem here?

But this has happened before!

When alternative trading systems emerged in the late 1990s, they were illegal exchanges under securities law because they were not broker-owned!

The S.E.C. approached the problem with no action letters and eventual changes in outdated rules

The Regulator's Dilemma

benign
crypto-assets

non-benign crypto-assets or crypto-assets that look like securities but are unregistered

crypto-assets that look like securities and are registered

crypto-assets that regulators feel comfortable to be traded on a platform under their supervision