Andreas Park PRO
Professor of Finance at UofT
Blockchain Technolgy & Decentralized Finance
Instructors: Andreas Park & Zissis Poulos
Rotman – MBA
5-minute version:
What is a blockchain?
blockchain=
an infrastructure for digital resource transfers
5-minute version:
What is a cryptocurrency?
cryptocurrency =
internal payment mechanism to pay for operation of a blockchain
5-minute version:
What is Decentralized Finance?
decentralized finance =
provision of financial services without the necessary involvement of a traditional financial intermediary based on blockchain technology
Why should you care?
Verbal Overview: Origins of Financial Institutions
- Money
- Safekeeping
- Deposit certificates and lending
- Trade facilitation & finance
in practice: new financial infrastructure that will be a common resource
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
Application: decentralized trading
Application: Decentralized Lending
\(\vdots\)
dapp-linking, Defi-Legos and flash loans
Source: Harvey, Ramachandran, and Santoro (2020)
Why should you care?
What questions arise from new tech?
- Do we need banks for safekeeping if AWS/Google/Microsoft hold the data = asset information?
- Why are transfers still hard and costly?
\(\Rightarrow\) Can we decentralize finance?
course content
questions we will address
- How does "decentralized" work?
- not cloud compution, but blockchain
- How does centralized work?
- What roles do intermediaries play?
- Can intermediation be decentralized?
- How do platforms work economically?
- What DeFi solutions are there?
The World of Banking is Opening
Is this a distant future?
Will there be banks in the future?
Is this a distant future?
- 900M WeChat Pay Users
- 84% market penetration
- >150K WeChat Pay users @GTA
Partnerships
Meanwhile, in the traditional world of finance
Business as usual?
Some Examples of (Past) Industry Leaders
Why worry about the distant future?
Nokia's market shares for devices:
- 2007: 49.4%
- 2012: 3%
What happened and can it happen to banks?
Examples: Blackberry and a generic bank
Paid-for vs. valued
- Keyboard
- Security
- Being businessy
- Cool and cutting edge
- Being Canadian
- Independence from desk
What did they pay for?
What do people value?
- Mobile email
- Brand name
- Easy access to branch
- Great product range
- Fair prices
- Great advice
- Latest tech
- Friendly tellers
- Safe-keeping of assets
If banks move all data into "the cloud," why do we need banks?
What took the place of Blackberry?
Major Lesson: Platforms provide value
What took the place of Blackberry? The App-Phone
Past, Present, and Future
Who will provide the next gen banking platform?
Siloed banks
Cloud computing and cloud storage
Open banking and open data
The past (and the present?)
The present and near future
3-5 years in the future
5-10 years in the future
Platforms?
Banks?
Tech firms?
- Each bank has a separate data center
- high costs
- no scaling
- little network externalities
- AWS etc
- Use specialized IT providers
- Network with external providers (FinTechs)
- Share data with external parties at customer request
- Platforms will emerge
- Customers can switch at the drop of a hat
- How will basic banking work?
- Who will run the platform and how will you survive on a platform?
- What will a platform work in financial services look like?
- What roles will current banks play?
- How will a bank earn money in a platform world and with which services?
Silos vs Common Infrastructures
Illustration of Infrastructure Frictions: money transfers
Version 1: They use the same bank
Change ledger entry locally
Version 2: They use different banks but the banks have a direct relationship
Sue's bank transfers from Sue's account to Bob's bank's account
Bob's bank transfers from its account to Bob's account
Version 3: They use different banks that have no direct relationship
Sue's bank transfers from Sue's account to its own account
Bob's bank transfers from its account to Bob's account
Central Bank
Central bank transfers from Sue's bank's account to Bob's bank's account
International transfers
Sue's bank transfers from Sue's account to its own account
Bob's bank transfers from its account to Bob's account
use the Swift network of correspondent banks
Bottom Line
very complex
many parties
lots of frictions and points of failure
very expensive
Crazy thought: Wouldn't it be nice if there was a single ledger?
Existing solutions
Problem:
power concentration/Monopoly
Distributed Ledger/Blockchain Technology
- A "joint, single system"
- Features:
- secure storage of information and transfer of value
- guaranteed execution of code
- Promise
- open platform
- global reach
- frictionless finance
How does it all work and why?
How do we establish trust in commerce?
trustworthy People
long-term Relationships
reputation
contract law
institutions
What's needed for trust in anonymous deals?
Authority
Execution
Continuity
Authority
Do you have the item?
Do you have power over it?
Tool: "key" cryptography
Execution
Can we agree that it happened?
Tool:
consensus algorithm
Security and Continuity
Are the records immutable?
restricted permissions
really difficult to hack
premise of blockchain
no trusted parties needed
everything
in code
open to
anyone
platform or network
commerce thrives
How?
A deep dive into the "How?"
Cryptography: only Sue can spend her money
Authority
Execution
Problem: double-spending
How can we trust that
- sale happened and
- $$ only spent once?
Execution
Security
B3
B1
B2
B4
B5
Contains transaction from Sue to Bob
Question: Can Sue rewrite history?
immutability
No! Because: Economics!
Incentive to support longest Chain
B3
B1
B2
B4
B5
B6
Where to add a new block B7?
- Add to B3?
- => people after still more likely to add to B6
- lose "coinbase" reward
Altering the past?
B3
B1
B2
B4
B5
- needs to be faster than anyone after who adds to B5 and build a longer chain
- or needs to be able to mine repeatedly
B8
B7
B9
B10
B6
Contains transaction from Sue to Bob
Sue wants to undo the transaction by rewriting history with B6
Sue's objective
- Wants to undo this trade and cheat Bob by building alternative chain from B6
What does it take?
- needs to be predictably able to add several blocks to the chain without interference, or
- needs to be faster than anyone after who adds to B5 and build a longer chain, or
- needs to ability to reject new blocks that are added to B5 .
How does Proof of Work prevent this?
- mining success is random subject to resources spend:
- computers/GPUs
- electricity
- you need faster/more computers than 51% of the network
- current network power: 150million tera-hashes per second (blockchain.info)
Back of the envelope calculation
- hashrate: 150,000,000 TH/s
- best hardware (ASIC) has 110TH/s per unit
- => need 150,000,000 / 110 x 0.5 = 682,000 ASICs
- 1 ASIC costs around $10,000 (conservative)
- =>Cost = $6,820,000,000
- But it doesn't end here...Power consumption at 4.5GW
- => enough to power 1M homes in the US
Economic Analysis, Part II
Double spend attack prevention
- Validation rewards are taken as given, but they are crucial in
- determining incentives to participate,
- to support the chain, and
- to expense electricity and computing power
Basic idea of competitive equilibrium
aggregate mining cost = aggregate reward
Double spending attack
- expense resources but:
- win N block rewards until "confirmation" block
- ability to double-spend
condition that prevents it
(Chiu & Koeppl RFS 2018)
\text{mining reward} \times (N+1)N > \text{double spend amount}
How do you agree though that something happened, or, what is consensus?
How can we reach consensus? The Byzantine Generals' problem
How can we reach consensus? The Byzantine Generals' problem
Blockchain proof of work establishes consensus
Byzantine Generals' Problem
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Byzantine Generals' Problem
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Byzantine Generals' Problem
Equilibrium
- generals pick majority message
- successful consensus as long as no more than 1/3 cheats
Blockchain requirement
- reach Byzantine Fault Tolerant consensus
- trick: messages are hard to forge
Byzantine Generals' Problem
Proof of Work Protocol
A Byzantine Fault Tolerant Algorithm
This Hash starts with a pre-specified number of zeros!
Blockchain BFT
= 00000xd4we...
= 00000xd4we...
= 00000xd4we...
consensus is reached if hash starts with right number of leading zeros
PoW does two things
- selects a leader
- makes messages hard to forge
Blockchain BFT
Challenges
Proof of Work uses unsustainable amounts of energy
Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/
Ethereum is full and using it is expensive
Scalability projects for Ethereum
- Ethereum blocks have no size limit
- but: gas limit imposes computation limit and thus transaction limit
- note: in contrast to Bitcoin, Ethererum always announced that it would eliminate proof-of-work eventually
Root Problem
- Side Channels:
- Keep two-party interactions off the main chain and use chain only for terminal settlement
- Sharding
- instead of storing all info on all nodes, break up the blockchain into shards
- \(\to\) hard problem!
Solutions
https://blog.stephantual.com/what-are-state-channels-32a81f7accab
a better blockchain: Conflux
Greedy Heaviest Adaptive SubTree (GHAST) algorithm
- Blocks are assigned a weight according to the topologies
- Exists a deterministically heaviest chain called pivot chain
- An epoch contains one pivot chain block and its reachable blocks
Transaction Processing
- Blocks are processed sequentially ordered by epoch, topological order and id
- Only the first occurrence of the transaction is processed
- up to 4,000 tps for simple payment transactions
- Note: runs Solidity \(\to\) 100\% compatible with all Ethereum smart contracts
Disclaimer: token design strongly influenced by yours truly
going back to Budish (2018)
Selfish Mining Attack in CONFLUX
Serial Chain
Conflux Chain
In Conflux, withholding a block leads to greater anti-cone size
Intuition: Anticone = blocks created without properly referencing others blocks in its vicinity
Selfish Mining/Double-Spent Attack in CONFLUX
Key problem of Proof-of-Stake:
How to incentivize support of longest chain?
B3
B1
B2
B4
B5
B6
Where to add a new block B7?
- PoW: only longest chain
- PoS: could add both at B3 and B6 (nothing-at-stake)
- solution: punish deviations!
My personal problem: I have not yet seen a convincing theoretical model of PoS
economic result: Fahad Saleh (2021) Review of Financial Studies, "Blockchain Without Waste: Proof-of-Stake" shows that PoS is an equilibrium
current state:
- promised since 2014
- secondary PoS chain in operation
- merger of chains expected in late 2021
Reality Check: Capacity
| 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
Miner extractable value and High Priority Gas Auctions
What can it for finance, what are problems and obstacles?
Obvious application: trading
Sue wants to sell ABX
Bob wants to buy ABX
sell order
buy order
Clearing House
Stock Exchange
Broker
Broker
3rd party tech
custodian
custodian
record beneficial ownership
central bank for payment
Evolution
With Blockchain: single ledger for money and securities
0xA69958C146C18C1A015FDFdC85DF20Ee1BB312Bc
0x91C44E74EbF75bAA81A45dC589443194d2EBa84B
0xA65D00Eda4eEB020754C18e021b1bF4E66C9Ed90
- blockchain 1.0
- first solution to double spending
- clunky, slow, expensive
- huge following and computing power
vs
- blockchain 2.0
- smart contract platform
- highly flexible
- foundation for many private initiatives
"Let me just say how impressed I am with Ethereum...If Bitcoin is email ––a one-trick pony, so to speak, but obviously revolutionary–– Ethereum goes far beyond that; it's more like the Internet...The whole idea of DeFi really is, number one, it’s obviously revolutionary, and I think at the end of the day could lead to a massive disintermediation of the financial system and the traditional players."
Heath P. Tarbert, CFTC Chairman, October 2020
Usage of blockchain in financial industry
Areas of applications
moving value (remittances)
digital money: real-time settlement, reduced reserves
tokenization of assets
automization of contract payments
securitization
systems and infrastructure reorganization
digital identity
new forms of financial contracts, assets, and forms of financing
What Changes in Business Models can Blockchain Technology bring?
What does blockchain do?
peer to peer value transfers
self-powered platforms
contract execution
disintermediation
Who do you dis-intermediate, and then who is your customer?
issuer
investor
broker-dealer
The Business challenge of dis-intermediation
investment advisor
Private Sector Solutions
Private vs. public
some key questions
Who gets to update?
Can a higher body prevent
transactions?
Can the past be altered?
consensus
immutability
censorship resistence
Public Blockchains provide
Main private blockchain systems
Features of Private vs. public blockchains
open to anyone
no one can be excluded
past cannot be changed
Public Blockchains
private Blockchains
high visibility of transactions
open-access eco-system
slow governance
privacy only at a cost
joint control and governance
straightforward KYC and AML
tech support
transaction secrecy simpler
rely on corporate development
compliance with law (reversion)
can keep competition out
Enter BigTech
cellphone data from 2018 (NewZoo), inflation from 2020 (World Population Review)
Evolution
DIEM = "new financial infrastructure"
Why does BigTech enter the finance game?
They have ZERO interest in becoming a financial institution/bank
\(\rightarrow\) no expertise
\(\rightarrow\) competitive market
\(\rightarrow\) one of the most regulated business environments
My take
They are trying to deal with frictions that impede their business
They aim to collect data which will vastly improve their business
Lay the groundwork for the next step of the digital evolution: the "Metaverse"
5-minute version:
Finance, Metaverse, and Non-Fungible Tokens
metaverse =
marriage of the digital and physical world
sale price: $69,000,000
What is an NFT?
- "unique" token
- digital ownership certificate
- ERC-721 standard (also ERC-1155)
Why bother with an NFT?
- difficult legal question: what do you actually own?
- allows royalty payments
- could be used in other tools (e-book readers)
- NFTs can be tokenized (partial ownership)
- used as collateral in DeFi
Metaverse application
- ownership in the digital world
- payment for digital experiences
Related Development: Central Bank-Issued Digital Currencies
Evolution
CBDCs
Newest Developments: CBDC
CBDC = Central Bank issued Digital Currency
not a cryptocurrency \(\to\) just a "normal" liability on central banks balance sheets
-
BIS Jan 2019: "Proceed with caution"
-
BIS Jan 2020: "Impeding Arrival"
Is it coming?
players (inter alia)
-
China: in test mode; provinces prep own initiatives, coming next year
-
U.S.: has bigger problems and is always a last mover
-
UK: preparing
-
Canada: contingency planning (it'll happen within two years)
players (inter alia)
Source: CBDCTracker.org
Risks and open problems
- many apps are still experimental, many kinks need ironing, and tech progress is needed
- smart contract risk:
- detecting problems with code
- detecting problems with economic incentives
- foreseeing unforeseen contract contingencies
- contract contagion risks
- governance of decentralized organizations
- role of regulators
The Ugly Truth: token trading and token markets are different from securities trading and markets
Investor
Broker
Venue
Settlement
Exchange
Traditional
Wholeseller
Darkpool
Internalizer
Venue
Settlement
Investor
On chain
Crypto
Key Challenges for the blockchain Community for 2019
Technology
Legal/Regulation
Economic functions
What is the right governance structure for systems?
How should we design tokens as contracts?
How do platform payment means interact with outside world
How much do we have to pay operators to maintain the chain?
Key Economic Questions for Blockchain Design
Key Technology Questions for Blockchain Design
interoperability
cybersecurity and privacy
functionality
scalability
smart contract features and verification
space constraints
Solution projects to Key Technology Questions
interoperability
scalability
space constraints:
Does the law have to change to accommodate new tech? If so, how? What's dated, what's not?
Key Legal Questions for Blockchain Design
Legal setup of a platform: what rules can, should, and must a platform establish? What regulations are necessary?
How can token design and the law be married?
Questions for the future
What is the economic impact of "tokenizing everything"?
How will it affect investments and investment banking?
Which business opportunities will it enable?
What do tokens and "alternative money" mean for payments?
Private vs. public
some key questions
Who gets to update?
Can a higher body prevent
transactions?
Can the past be altered?
consensus
immutability
censorship resistence
Public Blockchains provide
Main private blockchain systems
Features of Private vs. public blockchains
open to anyone
no one can be excluded
past cannot be changed
Public Blockchains
private Blockchains
high visibility of transactions
open-access eco-system
slow governance
privacy only at a cost
joint control and governance
straightforward KYC and AML
tech support
transaction secrecy simpler
rely on corporate development
compliance with law (reversion)
can keep competition out
Crypto vs Money
Cryptocurrency = money?
Can bitcoin or ether replace "fiat" MONEY?
store of value?
unit of account?
method of exchange?
A short history of Money
A short history of Money
A short history of Money
A short history of Money
A short history of Money
Cryptocurrencies vs USD
Cryptocurrency = money
Can bitcoin or ether replace "fiat" MONEY?
store of value?
unit of account?
method of exchange?
Cryptocurrencies are (currently) useless as money
cryptocurrencies' volatility?
Cryptocurrencies are (currently) useless as
money
fiat money cannot be used in smart contracts on the blockchain
solutions:
stablecoins
central bank digital currency
BTC, ETH
fiat: USD, EUR
asset (gold)
fee-backed
Seigniorage
Crypto
Traditional
Algorithmic
Collateral-Backed
Taxonomy of Stablecoins
$174M
$33M
$144M
funding figures from Nov 2018; source: blockchain.com
The One the world is talking about
What is Libra and how does it work?
issued by a consortium of firms (e.g., Facebook, Mastercard) and not for profits (Creative Destruction Lab)
each coin will be backed by a basket of SIX fiat currencies
idea is conceptually similar to IMF Special Drawing Rights (pegged to USD, EUR, YEN, GBP, YUAN)
Survey Info on Libra
Would you use Libra/Money issue by Tech Firm?
If we ask explicitly for Facebook vs Tech Firm
Scaled to yes/maybe/no. About 20% say: "Need more info"
Cumulative Token sales since Jan 2016
Data: coinschedule
$25B total
$21B in 2018
for comparison: total size of
-
Toronto Stock Exchange: $2,200B
-
Toronto Venture Exchange: $41B
Some spectacular returns
Source: Tokendata
The Ugly Truth: Scams
Source: Satis Group LLC
The Ugly Truth: Failure Rate
Source: Morgan Stanley (Nov 2018) “Update: Bitcoin, Cryptocurrencies and Blockchain”
Source: Tokendata
Also: a real horrow show
Key: you cannot collect money from just anybody!
The Ugly Truth: Many tokens are securities
Blockchain Tokens and Coins as Payments: a New Financing Tool?
- Since Jan 2016: $31 billion for 1,700+ early start-ups
- TMX Venture (successful, since 1999, for junior firms)
- $42 billion market cap (since 1999!)
- In 2018: 52 IPOs, $2.2 billion
- Private markets in Ontario: raised $70 billion in 2017
Lessons?
- Significant interest in FinTech
- Appetite by retail investors for risk/early-stage firms
- Possible to raise funds directly from investors
- VCs and intermediaries do provide a service
- money does not substitute for business plan/advice
- "wisdom of the crowd" is non-existent (?)
Tokens as Payments: a New Financing Tool?
Preliminary (academic) Research insights: What can (utility) tokens finance that traditional securities cannot?
can finance projects that otherwise would find no debt or equity funding
enable network effects and new business opportunities
allows entrepreneurs to extract more surplus
can finance projects that otherwise would find no debt or equity funding
Blockchain Tech Stack: Tokens vs Cryptocurrencies
Infrastructure
reward
and
internal currency
usage fee
or
incentive
usage fee
Service
Application
Tech Stack Layer
Role of Token
cryptocurrency
Token
Token
What Changes in Business Models can Blockchain Technology bring?
What does blockchain do?
peer to peer value transfers
self-powered platforms
contract execution
disintermediation
Who do you dis-intermediate, and then who is your customer?
issuer
investor
broker-dealer
The Business challenge of dis-intermediation
investment advisor
economics of Platforms are tricky
-
is it worth it for me to engage at all?
-
is the desired action of the platform the best for me?
Not everything that can be measured matters and not everything that matters can be measured
-
must be aligned with long-run goal of platform
-
must be under the control of platform participant
What does the platform need people to do?
Is there a suitable performance metric?
Utility tokens fail \(\Rightarrow\) not good platform tokens
Equity tokens fail too!
Observation: many Decentralized Apps = platform for two-sided, dis-intermediated market
Question 3: Do you need to incentivize the establishment of trust?
Question 2: What kind of incentives can you provide?
Question 1: What role does the intermediary play, what service does it provide?
-
Trust
-
Matchmaking
-
Time/size intermediation
-
marketing
quick comparison
FinTech vs. Defi
FinTech
DeFi
- more user-friendly UX
- more customer-oriented
- less squeezing/rent-extraction
- more competive services
- more innovative services
- currently: horribly user-unfriendly
- "blowing up the banks"
- fundamental re-thinking of financial services
- lots of scams, cowboy-attitude towards laws
innovation vs. salesmanship
main focus
Conclusion and final thoughts
blockchain is a transformative technology, but won't be used in practice overnight
many conceptual and technological challenges remain, but there are already various areas of application
legal, regulatory, and competitive changes are needed and then the opportunities are endless ...
it will open up the banking world further, foster international competition, and change how we pay and exchange value
My view: business development will happen in private/semi-public space; strong increase in recent activity; no more testing but re-engineering of processes.
@financeUTM
andreas.park@rotman.utoronto.ca
slides.com/ap248
sites.google.com/site/parkandreas/
youtube.com/user/andreaspark2812/
Decentralized Finance: Introduction (MBA) v2021
By Andreas Park
Decentralized Finance: Introduction (MBA) v2021
This is the slide deck that I use for a quick introduction to the Decentralized Finance class.
