Andreas Park PRO
Professor of Finance at UofT
Blockchain and Decentralized Finance:
A 2023 Primer
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?
- What happened with FTX & Terra and what's happening in the regulatory space?
- Getting your hands dirty!
What is a Blockchain?
What is a Cryptocurrency?
Conceptually, what is a blockchain?
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
A blockchain is a
- general purpose
- open access
- value management
- infrastructure
- that is communally run
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
custodian
beneficial ownership record
seller
buyer
Broker
Broker
Application: decentralized trading with automated market makers
AMM Pricing
- Purchase \(q\) of asset
- Deposit cash \(\Delta c (q)\) into liquidity pool, extract \(q\) of shares
- liquidity before trade \(=\) after trade
\[L(a,c)=L(a-q,c+\Delta c)\]
Source of savings:
- better risk sharing among liquidity providers
- better use of capital
Possible transaction cost savings when applied to equity trading: \(\approx\) 30%
Source: "Learning from DeFi: Would Automated Market Makers Improve Equity Trading?" working paper, Malinova & Park 2023
Application: Decentralized Borrowing & Lending
borrow
provide collateral
The Flow of Event: Normal Times
The Flow of Event: Collateral Liquidation
Dapp composability ("DeFi LEGOS") & Flash loans
Interest rates: a function of pool usage
threshold usage rate
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
Platforms, Peer-to-Peer, and Decentralization
Philosophy of Peer-to-peer
Traditional Market
two-sided with fixed roles
- consumers \(\leftrightarrow\) producers
- consumers \(\leftrightarrow\) intermediaries \(\leftrightarrow\) producers
Decentralized Market?
value management protocol \(\not=\) market
- blockchain \(=\) application execution \(=\) intermediary
- blockchain-native \(\Rightarrow\) requires platform thinking
- consumers \(=\) producers
Peer-to-peer \(\Rightarrow\) Platforms
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?
it works!
A Consequence of Liquidity Mining: Yield Aggregators
Idea:
- strategy to systematically take advantage of token issuance (liquidity mining) programs
- like pooling funds to take advantage of banks deposit incentives
- liquidity flees quickly
- "mirage" effect: yield aggregators borrow what they deposit
Who controls the Projects? Decentralized Autonomous organizations
UniSwap Lab supports development
a website app accesses the code
token holders control contact features
don't own the code
operation = decentral
control = decentral
anyone can use the baseline code
core code runs on the blockchain
tokens used as rewards
A Taxonomy of Tokens
- tokens are a re-imagination of value, ownership, use, rewards
-
tokens live on a single infrastructure and can interact with other tokens
- tokens are immediately transferable & immediately usable in DeFi
- token can be programmed to have many features and have many different uses
- tokens can assign ownership to "things" that could not be owned before
- tokens are often important for the functioning and incentives of platforms
What's a crypto-token and what's special about it?
- a blockchain is a protocol in which
- users have direct control and responsibility over their assets
- users can create codes at will
- \(\rightarrow\) any user can create tokens and applications
Tokens by use
payments:
- you use them strictly to pay for something
- example: native cryptocurrencies
utility
- you use them to access a specific service of function
- example: filecoin
stablecoins
- digital representation of fiat money
- centralized/ decentralized
- examples: DAI, USDC, USDT
governance
- voting rights to determine parameters of a project
- example: UNI, Compound etc
asset
- representation of ownership
- pool claims, digital items
- example: receipts from UniSwap, Compound, NFTs
derivatives
- tokens based on other tokens & functions
- Example: tokensets
Disclaimer: this list in non-exhaustive, new ideas and concepts come up every day!
Stablecoins
BTC, ETH
fiat: USD, EUR
asset (gold)
fee-backed
Seigniorage
Crypto
Traditional
Algorithmic
Collateral-Backed
Taxonomy of Stablecoins
Asset-Backed stablecoins: USDT & USDC
Stablecoins: Digital Representations of the USD
BIS Survey of Central Banks:
The Terra Implosion
UST Stablecoin
LUNA (cryptocurrency of the TERRA network)
How did TUSD work?
- "algorithmic stablecoin" USDT
- network token LUNA
- \(\to\) a utility token for the TERRA blockchain
- \(\to\) has value if people value the network
- When 1TUSD > 1USD
- \(\to\) print more tokens
- \(\to\) inflation
- \(\to\) price TUSD \(\searrow\)
- When 1TUSD < 1USD
- \(\to\) exchange 1 TUSD for $1 of LUNA
- \(\to\) receive $1 worth of something that cost < $1
- \(\to\) demand for TUSD \(\nearrow\)
- \(\to\) price for TUSD \(\nearrow\)
- What is the problem?
- conversion leads to inflation of LUNA
- \(\to\) large conversions lead to inflation \(\to\) price drops in LUNA
- \(\to\) conversion takes time and price may drop too fast
- \(\to\) wrecks the arbitrage mechanism
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
- Canada has 800,000 international students
- admits around 300,000-400,000 annually
- Government of Canada: "We estimate that in 2017 and 2018 respectively, international students in Canada spent $18.4 billion and $22.3 billion on tuition, accommodation, and discretionary spending."
- Most of these funds are transferred from foreign countries to Canada in large sums.
- Students regularly get harrassed by tellers/banks about the source of their funds.
Canada is a country of international students
- To get admitted & get a visa you need to
- make a sizeable deposit
- prove that you have funds for tuition and sustaining your life
- How??? \(\to\) expensive brokers and other shady arrangements
Money Laundering and Crime
Banned addresses
criminals don't use USDC - why are we so worried?
Tornado cash
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
2022: the year of crypto crashes
From a slow slide to a thorough crash
-75%
-75%
!
A timeline
May 7: selling pressure on UST from Curve withdrawals
May 12: LUNA and UST at $0.01
June 27: Three Arrows Capital ordered to liquidate
June 12: Celsius Network suspends withdrawals
July 13: Celsius files for Chapter 11
July 6: Voyager Digital files for Chapter 11
July 4: Vault suspends withdrawals
Three Arrows Capital lost >60% of value and faces numerous margin calls that they did not react to
\}
partially "saved" by \(\ldots\) FTX
The FTX Implosion
A timeline
Nov 8
Recurring Core problem QuadrigaCX:
- QuadrigaCX:
- Gerry Cotton sold people crypto he did not have
- FTX:
- auto-execution of margin calls for all except Alameda
- SBF used customer funds to hide "short" market maker Alameda
Fundamental Problems: Solution sans Regulators?
IN FINANCE TERMS
- hedge = off-setting position
-
here: unhedged/"leverage"
Solution
- prove aggregate positions
- prove assets & liabilities
- asset = liabilities \(\Rightarrow\) solvency
New trend: data providers check assets
-
Assets: cash in bank accounts and crypto assets in exchange wallets
-
Liabilities: customers' crypto and cash deposits
-
Proof of crypto assets
-
publish all exchange wallets
-
proof of control: shift assets from one address to another at a pre-determined time
-
-
Proof of crypto liabilities
-
public customer balances - customer can check
-
own holding
-
sum of all
-
-
-
Problem: privacy (adequate solutions exist)
Proof of Assets & Liabilities
A timeline
May 7: selling pressure on UST from Curve withdrawals
May 12: LUNA and UST at $0.01
June 27: Three Arrows Capital ordered to liquidate
June 12: Celsius Network suspends withdrawals
July 13: Celsius files for Chapter 11
July 6: Voyager Digital files for Chapter 11
July 4: Vault suspends withdrawals
Three Arrows Capital lost >60% of value and faces numerous margin calls that they did not react to
\}
partially "saved" by \(\ldots\) FTX
all centralized!
Centralized vs Decentralized?
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
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
The Regulator's Dilemma
The Reality of Markets
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 you feel comfortable to be traded on a platform under your supervision
The Dilemma
- blockchain as an idea will not become uninvented
- there is continuous research & development, including by universities
- when another hype starts, people will want to get their hands on the assets
- blockchains are borderless by design
- "tough" regulation pushes firms outside of jurisdictions
- no regulation can prevent the bankruptcy of an offshore entity
- willing issuers want clear guidance
- but issuers of crypto assets cannot comply with current rules
Final Thoughts
Some Final Thoughts
- blockchain tech won't get uninvented.
- young people and universities keep working on blockchain ideas
- the space is still trying to figure things out, including tech and economic challenges
- great progress has been made, but things will and do still go wrong
- a common resource can have huge economic benefits
- I'd like to see more thinking and discussion about paths to unlock the benefits
@financeUTM
andreas.park@rotman.utoronto.ca
slides.com/ap248
sites.google.com/site/parkandreas/
youtube.com/user/andreaspark2812/
Are Tokens Securities and What Safeguards Should There Be?
- People want(ed) crypto assets and they will get their hands on them
- US style differentiation of securities vs commodities etc is neither helpful nor useful
- There is no such thing as "technology-neutral" regulation.
- Some rules from securities regulation simply cannot be implemented with blockchain tech
- Just because someone buys something with an investment motive doesn't mean that they should get all securities protections
Provocative Thoughts
- End of Theory -
Some Developments
- Soulbound tokens, digital ID, privacy zero-knowledge proofs
- improved user experience, e.g., SIM cards with blockchain wallets
- invisible blockchains (used in China for AliPay NFT storage)
Blockchain Infrastructure
seller
buyer
What is a Blockchain?
The Premise of the
Internet & Blockchain
Peer to Peer Communication
Peer to Peer Value
!
?
?
Sidebar: What is digitize-able value?
- money
- digitally native assets
- claims on resources and property
- identity, personal data
The challenge: how do you ensure digital scarcity?
- traditional approach: unique record-keeper
- problem:
- intermediary necessary for record keeping
- tight supervision of custodian
- no peer-to-peer
- What is the equivalent of TCP/IP for value?
CUES Leadership Presentation on DeFi RSM 2023
By Andreas Park
