Andreas Park PRO
Professor of Finance at UofT
Crypto-Economics
February 6, 2020
Andreas Park
Associate Professor of Finance, University of Toronto
Tokens as platform incentives
Cryptocurrency, Stablecoins, and Central Bank Money
Economic design of recording technology
Economic Questions are of First Order Importance for Blockchain
Scalability vs. Decentralization
Tokens as a new form of finance
Normal Business School Think: TWO dimensions
A small warning about the theme of this class:
THREE Dimensional thinking is required
Objective 1
Objective 2
A
B
X
Y
Blockchain Thinking: THREE Dimensions
A small warning about the theme of this class:
THREE Dimensional thinking is required
Objective A
Objective B
Objective C
Common issue: You can't have your cake and eat it
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
The Impossible Trinity (macroeconomics)
free flow of capital
Control exchange rate
Control interest rate
Basic macroeconomics: you can have TWO out of THREE
Why? The inconvenience of markets ...
Central Bank Digital Currency (CBDC)?
Timothy Lane (Deputy Governor Bank of Canada, Philadelphia Fed FinTech Conference, November 15, 2019):
-
"We are no longer experimenting, we are not in the contingency planning stage"
-
"Should stablecoins take off, then we may trigger this option to maintain our ability to fulfill our monetary policy mandate"
Mark Carney (Governor Bank of England, Jackson Hole Symposium Auguste 2019):
-
"Technology has the potential to disrupt the network externalities that prevent the incumbent global reserve [the USD] currency from being displaced. "
-
"the relatively high costs of domestic and cross border electronic payments are encouraging innovation"
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"it is an open question whether such a new Synthetic Hegemonic Currency (SHC) [like Facebook's Libra Coin] would be best provided by the public sector, perhaps through a network of central bank digital currencies."
Source: Will Libra Succeed? Results of a Global Randomized Survey Experiment; by Danielle Goldfarb and yours truly
Will people use Libra?
external punishment
\(\to\) misbehavior results in commercial/legal/social punishment
We must trust that records are correct. How achieved?
Economic Design of Recording Technology
allow rents:
\(\to\) running the ledger is profitable
\(\to\) misbehavior causes lack of trust
\(\to\) lack of trust makes people not use the ledger
\(\to\) rents gone
physical resource cost
\(\to\) running the ledger is costly
\(\to\) if I misbehave in the future then lack of trust
\(\to\) my previous investment is destroyed
resource efficient
What features would we like a blockchain to have?
Economic Design of Recording Technology
cheap (or: no rent extraction/competitive operation)
self-powered (no external force needed)
Triangular problem for current blockchain technology
resource efficient
no rent extraction
self-powered
proof-of-work blockchains
proof-of-stake blockchains
centralized
You can't have your cake and eat it ...
based on: Blockchain Economics by Abadi & Brunnermeier 2019
Sideboard: even "rent-free" is not clear...
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}
One would think that
-
competitive mining \(\Rightarrow\) zero profit or
-
blockchain \(=\) infrastructure \(\Rightarrow\) reward \(=\) commodity/risk-free rate
scalable
What operational features would we like a blockchain to have?
reliable consensus
decentralized
Conceptual Scalability Concerns
Triangular problem for current blockchain technology
reliable/secure
decentral
scalable
proof-of-work blockchains
proof-of-stake blockchains ...?
centralized like VISA
based on: A Brief Introduction to Blockchain Economics by Chen, Cong, and Xiao (2019)
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 | 3500 | 151,200,000 |
| Athereum | 5000 | 216,000,000 |
| Payments Canada retail | 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 |
Bitcoin: first blockchain, one trick pony
Quick Chain Comparison
Ethereum: decentralized computing, still developing
Athereum: Ethereum with the Avalanche consensus protocol & proof-of-stake
developed by Andrew Yao (MIT) & Fan Long (UofT)
Two problems with Ethereum
Conflux's Approach
serial processing of blocks \(\Rightarrow\) limited throughput, long latency
contracts occupy space forever without ever paying for it
parallel processing of blocks using graph theory
storage costs through bonding of tokens + inflation
Blockchain-based platforms: What Changes in Business Models can Blockchain 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 chicken-and-egg problem of dis-intermediation: how do you prime the pump?
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
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 (?)
Is there economic merit to token-finance?
Do financing tokens solve an economic problem?
State of Debate on Tokens
Blockchain Tech Stack: Where would tokens matter?
Infrastructure
reward and
internal currency
usage fee
or
incentive
usage fee
Service
Application
Tech Stack Layer
Role of Token
Tokens as Seignorage Money to Power a Network
Infrastructure
reward and internal currency
Sustainability of network security
Chiu & Koeppl (2016), Budish (2018)
How do cryptocurrencies have value?
Biais, Bisiere, Bouvard, Casamatta (2016),
Schilling and Uhlig (2018)
Cryptocurrencies as payment for "real" costs
Sockin and Xiong (2018)
Development and subsequent seignorage
Canidio (2018), Catalini and Gans (2018)
Blockchain Platforms: Economic Transactions with "Decentralization"
Two-sided markets with fixed roles
Consumers - Producers
Consumers - Intermediaries - Producers
Traditional economy
Multi-sided or peer-to-peer markets
Consumers = Producers
requires platform building
Decentralized economy
Traditional "centralized" economy
Service Platform Tokens: Enabling Decentralization?
usage fee or incentive
Service
How do you get people to contribute to a peer to peer platform?
Li and Mann (2018)
How do you finance development without future income flow?
Canidio (2018)
What is the relationship between token prices and platform adoption?
Cong, Li, and Wang (2018)
Tokens as Payments: a New Financing Tool?
usage fee
Application
What can (utility) tokens finance that traditional securities cannot?
Chod and Lyandres (2018):
- Token \(\Rightarrow\) underinvestment, except under VC under-diversification
Davydiuk, Gupta, and Rosen (2018)
- Token retention policy is a quality signaling tool
Lee and Parlour (2018)
- Tokens as crowdfunding tool that allows producers to extract untapped customer surplus
Malinova and Park (2018)
- Tokens \(\equiv\) output pre-sale; generically equivalent to debt and equity and better than equity under moral hazard
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?
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/
price
An Economic Model of ICO
- entrepreneur wants to produce a good or service
- Demand is uncertain and only revealed after production.
- \(\Rightarrow\) maximizes monopoly profits
demand
marginal cost
marginal revenue
general idea: sell future output
two approaches for token sales
sell a fraction of future revenue
sell units of future output
Token Financing
- we call it revenue sharing
- we call this output presale
price
demand
marginal cost
marginal revenue
Entrepreneur does not internalize the effect of an extra output unit on the token value for the tokenholders!
Result: overproduction
Output Presale
price
demand
marginal cost
marginal revenue
Result: underproduction
NB: Similar to Chod and Lyandres (2018)
Revenue Sharing
\(\Rightarrow\) shifts marginal revenue for entrepreneuer left because get only fraction of revenue
revenue sharing: underproduction
output presale: overproduction
\(c\)
\(MR\)
"does not internalize" = externality
address externality: TAX!
here: tax future token income
incremental token income gets shared
\(\Rightarrow\) combine the two to get the monopoly quantity!
- issue \(t\) tokens ex ante
- share \(\alpha_t\) of new tokens
- token share \[\alpha_t=\frac{t}{c+t}\]
Is token financing inferior?
Is token financing inferior? No!
Idea:
entrepreneur can influence expected demand
- costs her more but
- more likely to get high demand
with effort
without effort
common topic in corporate finance
very relevant in "decentralized" world where developers are scattered around the globe
also applicable to, e.g. established firms that do something new
assume \[\textit{NPV}(\text{effort})>0>\textit{NPV}(\text{no effort})\]
Token Issuance with Moral Hazard
- costs her less but
- more likely to get low demand
Investors (equity or token holders) only finance the project if the entrepreneur undertakes the effort
Solve for the optimal funding conditional on the entrepreneur taking the effort
Derive conditions such that the entrepreneur undertakes effort
Token Issuance with Moral Hazard
1.
2.
Key insight: a token contract incentivizes effort better than equity (similarly to canonical debt vs. equity insights)
Optimal token contract has debt features:
get nothing if demand is low (only original
tokenholders get anything)
benefit if demand is high
all projects that can be financed by equity can be financed by the optimal token contract but
Token Issuance with Moral Hazard
some projects that can be financed by optimal tokens contracts cannot be financed by equity.
Simple model of revenue-based ICO vs equity financing from the standard corporate finance + IO toolbox
Theorem 1: Without frictions, an optimal token contract finances the same
projects as equity
Theorem 2: With entrepreneurial moral hazard,
any equity-financeable project can be financed by an optimal token
some token-financeable projects cannot be financed by equity
\(\Rightarrow\) There is economic and conceptual merit to token financing
Summary
Economics of Blockchain for DeGroote 2020
By Andreas Park
