Blockchain and Decentralized Finance:
A 2023 Primer
Presenter: Andreas Park
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
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
payments network
Stock Exchange
Clearing House
custodian
custodian
beneficial ownership record
seller
buyer
Broker
Broker
AMM Pricing
Source of savings:
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
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
Decentralized Market?
value management protocol \(\not=\) market
Peer-to-peer \(\Rightarrow\) Platforms
liquidity \(\nearrow\)
volume \(\nearrow\)
protocol fees \(\nearrow\)
token value \(\nearrow\)
Platform economics is tricky:
it works!
A Consequence of Liquidity Mining: Yield Aggregators
Idea:
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
What's a crypto-token and what's special about it?
Tokens by use
payments:
utility
stablecoins
governance
asset
derivatives
Disclaimer: this list in non-exhaustive, new ideas and concepts come up every day!
Stablecoins
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?
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:
Money Laundering and Crime
criminals don't use USDC - why are we so worried?
extra info:
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
Fundamental Problems: Solution sans Regulators?
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
services
needed & provided
A general purpose value management infrastructure:
intermediaries
separate institutions
The blockchain reality:
new institutions
emerged that do all three
tokens are often not intended to be investments!
... and that brought us ...
Regulators' Focus
MiCA
What is a security and why does it matter?
"What's the big deal \(\to\) just download a form from our website and register!"
\(\Rightarrow\) people (may) buy token with investment motive
\(\Rightarrow\) require protection from securities law
What is a security and why does it matter?
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
Final Thoughts
Some Final Thoughts
@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?
Provocative Thoughts
- End of Theory -
Some Developments
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?
The challenge: how do you ensure digital scarcity?