Blockchain and Financial Economics

The Thirteenth Annual Berkowitz Lecture

FinTech: The Regulator's View

The Growth of Finance as % of GDP

Source: Philippon (AER 2015) "Has the U.S. Finance Industry Become Less Efficient?"

Much of growth is fees...

Source: Greenwood & Scharfstein (JEP 2013) "The Growth of Finance"

... and unit costs are flat!

Source: Philippon (AER 2015) "Has the U.S. Finance Industry Become Less Efficient?"

Workers in the Finance Industry benefit greatly from growth of finance

• Philippon and Reshef (QJE 2012):
  • 1980: wage financial services=wage other industries​
  • 2006: financial services=170% x other
• ​​​Goldin & Katz (AER 2008)
  • ​​1969-74: 6% of Harvard grads went to Fin Industry
  • ​2006: 28%
• Oyer (JF 2008):
  • ​​wages Stanford GSB grads in finance industry
    • ​​300% of wages in non-finance

What drives high wages?

Deregulation or complementarity to IT?

Source: Philippon & Reshef (JEP 2013)

What explains high cost?

• High quality?
  • ​​​Bai, Philippon, Savov (JFE 2013): No, markets haven't become any better/more informative.
• ​​​​Better allocative efficiency?
  • ​​​Aguiar and Bils (AER 2015): no improvement in risk sharing.
  • ​​​Hsieh and Klemp (QJE 2009): no improvement in potential gains from TFP across time.
  • ​=> no evidence.​
• There is a dispute whether growth in finance has actually brought benefit to society ...

• Finance is very expensive.

• ​People earn relatively high wages.​​​

What do we know from the long history of capitalism?​

Disruptive entry is bound to take place!

My View

• Financial Industry is self-contained
  • for many years, hired a "certain" type of person
  • "fixed" set of tech vendors
  • access to financial infrastructure essential
    • outside disruption difficult
• Technological advances have the capacity to break into the industry

Example: One of the first segments that were disrupted from the outside: equity trading

Old Days of Trading: highly specialized humans

Old Days of Trading: highly specialized humans

Modern Day Trading

Autonomous Algorithms run the show

Modern Day Trading

And the former heart of Wall Street is now in a faceless & glamourless suburb

Why?

• Many trading strategies are more-or-less mechanical/probabilistic
• computers are
  • faster,
  • cheaper, and
  • more reliable 
• Computer algos allow much wider scope

Source: Bloomberg News, Feb 20, 2015

Note: The biggest disruptors (the HFTs) came from the outside of the traditional system (kinda).

And what's the result?

entire career streams disappear

The HR Component

• Old skill-set of an equity trader
  • good and fast with numbers
  • brash
  • strong vocab in profanities
  • whatever this koala has...
• New skill set
  • programming
  • stats/data
  • econometrics
  • => increase scope

And what's the result?

Markets get better

Source: Martineau (future UofT faculty) (WP2017)

And what's the result?

Markets get better: the post earnings announcement drift had been a long-standing puzzle in finance

Source: Martineau (future UofT faculty) (WP2017)

Much of the financial industry will see similar changes as the world of trading!

What is it that a bank does?

obtain & store information/data

process information

make decision

allocate capital

monitor and revise

automation

!

!

?

AI?

AI?
ECO?

Obstacles

Source: Philippon (2017)

• non-integrated IT systems

My view of the dinosaur

• cumbersome legacy system
• unintegrated databases
• silo-ed data
• back-office infrastructure that requires many parties
• rigid regulatory framework

And this is where Blockchain comes in...

You just know it's important when it makes it to Dilbert

Why is Blockchain Important? What can it do?

• World Wide Web:

  • frictionless electronic transfer of information

• Blockchain:

  • ​frictionless electronic transfer of value

Illustration: Money Transfer

Illustration: Money Transfer

Illustration: Stock Trade

Illustration: Stock Trade

Take Aways: Intrinsic Features of Blockchain

• Blockchain requires no
  • "accounts"
  • dealers/brokers/bank
• Blockchain does require
  • distributed network 
  • entities that process transactions
• Blockchain ledger can be very transparent
  • => design choice.
• Peer-to-peer is possible.
  • Who is your peer?

Economic Questions

• Macro:
  • Without accounts => fewer deposits
    • How will fractional banking work?
• Micro:
  • Settlement is immediate:
    • how will this impact intermediaries?
  • Validation by network is crucial:
    • How do you pay for validation?
  • Ledger is distributed across the network
    • Who can see how much of the ledger?

Existing Research on Macro/Banking

Parlour, Rajan, Walden (WP 2017): "Making Money: Commercial Banks, Liquidity Transformation and the Payment System"

Banks do three things

1. accept and keep (cash) deposits
2. transform deposits into digital claims (e.g. loans)
3. process payments

Existing Research

Macro: impact on payment

Paper Idea (Parlour, Rajan, Walden 2017)

• banks are strategic players
• make loan based on expectation of cost in interbank market
• result: 
  • tech improvements in deposit market can cause poor allocations in credit market

Existing Research on Settlement Speed

Khapko & Zoican (WP 2017): "'Smart' Settlement

                                                     on the Blockchain"

(UofT faculty)

Observations:

• switch from t+3 to t+2 vs. t+1 is operationally more costly by an order of magnitude
• blockchain = immediate settlement
• economic trade-off:
  • slow=more counter-party risk
  • fast=intermediaries must commit capital immediately

Existing Research on Settlement Speed

Khapko & Zoican (WP 2017): "'Smart' Settlement on the Blockchain"

(UofT faculty)

Results

• fast settlement can lead to lower liquidity
• in flexible world, see specialization with
  • high cost, fast settlement and
  • low cost, higher counterparty risk

Existing Research on Settlement Incentives: None yet

(but Khapko, Malinova, Park, Zoican have registered a proposal)

Bitcoin blockchain transaction delays and unconfirmed transactions

Source: Blockchain.info

Existing Research on Settlement Incentives: None yet

(but Khapko, Malinova, Park, and Zoican have "registered a proposal")

Bitcoin blockchain confirmation delays and incentive payments

Source: Blockchain.info

Existing Research on Ledger Transparency

Malinova & Park (WP 2016): "Market Design with Blockchain Technology"

Observations:

• Blockchain enables peer-to-peer trading
  • enable transactions outside of current infrastructure
  • enable directed search/contacting
  • smart contracts can facilitate peer-to-peer interaction
• Blockchain allow ledger transparency
  • => possible to know who owns what
• Market participants can obfuscate transparency by spreading holdings

What do you know and what do you not know in OTC?

What do you know and what do you not know in Peer-to-Peer?

Key Research Question

How does the design of ledger transparency and identifier-usage with possible P2P interactions affect trading behavior and economic outcomes?

• different ledger transparency regimes are possible
  • ledger is open to all
  • ledger is hidden
• different identifier-usage regimes are possible
  • use single IDs per entity
  • use arbitrary number of IDs

Who benefits and loses under which regime?

Setting I: Non-transparent & concentrated ownership

Setting II: Transparent & concentrated ownership

Setting III: (Non-)Transparent & dispersed ownership

Economic Tensions

• search is costly
• trading with intermediary
  • expensive
  • externality of large on small
• best if large interact, but:
  • risk of front-running
  • front-running comes at reputation loss
    • think: AirBnB or Uber reciprocal rating
• when do social norms have bite?

Acceptance Probabilities

small traders

large trader

small traders

large trader

small traders

large trader

filled

unfilled

Setting I:
non-transparent, single IDs

Setting III: large accept

Setting III: large reject

small traders

large trader

Setting II:
transparent

Equilibrium Outcomes

1. Non-transparent, single IDs
   • always mix
2. Transparent, single IDs
   • social norms always work
   • with frequent interactions, no price concessions necessary
3. Non-transparent, multiple IDs
   • large interact if 
     • interactions frequent/reputation important
     • outside option cheap
     • mining costs high enough
     • but: price concessions may be necessary

So which market design is best?

1. Transparent, single IDs always best
   • because social norms work
2. non-transparent:
   • when with multi-ID large interact, always best
   • when they don't interact, multi-ID better only if 
     • outside option cheap
     • search costs high

Central Takeaway

• Market design choices are critical
• benchmark: transparency is best
• ID allocation matters
  • => must understand market details

FinTech, Blockchain, and Financial Economics

What are the economic questions and how can economic analysis help us understand?

The Use of Economics for Blockchain Design

• discussion on blockchain dominated by
  • technological solutions
  • feasibility
  • cost savings
• my point
  • critical to understand economic mechanisms
  • back office changes will affect the front office
  • understand the new business models
• markets with rules and a microstructure
  • build-in frictions
  • => understand these using economic analysis!
  • => and that's what we trained you to do!