Andreas Park PRO
Professor of Finance at UofT
Decentralized Finance:
A Primer
Presenter: Andreas Park
Agenda
- Background:
- Vocabulary & Evolution
- What's DeFi and what's different to TradFi?
- What do we know about tokens?
- What every finance professional needs to learn
- Outlook
A tumultuous time since April 2022
The NFT Boom
- "what is the real value proposition here? [...] probably nothing.”
- "[...] a lot of people have grown weary of cash-grab tactics.”
The NFT Boom & Crash
The Terra Implosion
UST Stablecoin
LUNA (cryptocurrency of the TERRA network)
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
What's next?
The Aftermath:
is crypto dead or dying?
Disclaimer: I wrote the following before, eh, ... last week...
Cryptomarket Crash
bitcoin
ETH
-70%
-60%
Consequences of the Crash?
Some Questions
- Are blockchains no longer used?
- Is crypto investing dead?
- What other effects does the crash have?
Are blockchains no longer used?
transactions on Ethereum flat
Is crypto-investing dead?
crypto market follows traditional market
Is crypto trading dead?
trading volume on exchanges lower but steady
Are markets dead?
no meaningful net outflows from exchanges
Other consequences?
- less hype will
- attract less new capital
- separate grain from chuff for projects
- lower distractions
- lower token prices
- make working in crypto less attractive
- make it harder for projects to pay people
What is a Blockchain?
Examples of research questions in the literature
- is "works-as-intended" an economic equilibrium?
- differences between consensus protocols
- consensus incentives
- impact of incentives on security
- security and pricing
- impact of scaling
What is a Cryptocurrency?
Contribution of economic research
- design of the fees after the "London Fork" (split of fees into mandatory v. "tips", cost of processing and space)
Addresses, Accounts, Wallets, and Public/Private Keys
Smart contract accounts
- controlled by code
- decentralized applications
- tokens
Externally owned accounts
controlled by private keys
private
key
public
key
seed phrase
public
address
wallet = software to keep and use private keys
Research: known, well-established mechanisms in mathematical cryptography/number theory
What is Decentralized Finance?
decentralized finance =
provision of financial services without the necessary involvement of a traditional financial intermediary
DeFi: new financial infrastructure that will be a common resource
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
trading Infrastructure
payments network
Stock Exchange
Clearing House
custodian
custodian
beneficial ownership record
seller
buyer
Broker
Broker
Blockchain Infrastructure
seller
buyer
Examples of research questions in the literature:
- illicit funds for Bitcoin
- changes in the informational environment and impact on trading behavior
What makes DeFi different from TradFi
Application: decentralized trading with automated market makers
New institutions!
- passive "shared" liquidity provision
- new pricing function
\(X-Q\)
\(X\)
\(Y+P(Q))\)
\(Y\)
\(c=X\cdot Y\)
automated market makers Pricing Function
- remove \(Q\) of one token
- must add \(P(Q)\) of other token
- so that liquidity stays invariant \[L(X,Y)=L(X-Q,Y+P(Q))\]
- Common rule: constant product \[X\cdot Y=(X-Q)\cdot (Y+P(Q))\]
Examples of research questions in the literature
- liquidity provision and trading costs (empirical and theoretical) AMM vs traditional market
- liquidity provision with baked-in pricing function
- impact of trading fees on liquidity provision
- costs of liquidity provision
- competing trading systems
- determinants of liquidity provision
- performance of AMM pricing vs LOB pricing
Dapp composability & Flash loans
1. flash-borrow DAI
5. repay DAI
3. receive ETH
4. convert ETH to DAI
2. liquidate ETH loan with DAI
Loan liquidation opportunity
Examples of research questions in the literature
- system risk from liquidations
- contagion risk
- price impact from liquidations
Securities Creation: Tokensets
idea: create new mutual fund like asset
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
DAO Tokens & Yield Farming
- Liquidity pool example
- trading requires liquidity
- need to attract liquidity
- offer early adopters DAO token that contains claim on protocol fees
liquidity \(\nearrow\)
volume \(\nearrow\)
protocol fees \(\nearrow\)
token value \(\nearrow\)
Insight: protocols use tokens that have equity features as incentives to users
Examples of research questions in the literature
- corporate finance of different types of tokens
- tokens as commitment devices
- token network effects
Vampire Attacks: SushiSwap vs UniSwap
Source: https://finematics.com/vampire-attack-sushiswap-explained/
- Idea: syphon liquidity from a different protocol
- Mechanism:
- deposit in UniSwap, receive LP token
- deposit LP token to Sushi, receive rewards
- liquidate LP token and migrate original liquidity to Sushi = "suck out the blood from UniSwap"
Examples of research questions in the literature
- HBS paper that goes for splashy title and is otherwise descriptive
Does it matter economically?
Broker
Exchange
Internalizer
Wholeseller
Darkpool
Venue
Settlement
Examples of research questions in the literature
- papers on manipulative practices on unregulated venues, e.g., wash trading, pump-and-dumps, price manipulation by selling thin air
approx:
400B p.m.
approx:
700B p.m.
- Daily volume of decentralized trading commonly exceeds that of Coinbase
- Fees earned on DEX per day exceed several millions
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
What's a crypto-token and what's special about it?
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!
Examples of research questions in the literature
- stablecoin related: "un-tethered Tether"
- usage of tokens for tax harvesting
Examples of open research questions
- lots!
- DAO governance (voting etc.) and optimal tokenholder participation
- roles of tokenholders
- macro implications of stablecoins & stablecoin design with interest rates
- tokenization of existing assets
- analysis of DeFi lending protocols
Practical questions that arise
What do I look for in a token?
- What is the use case for the token?
- investment asset with cash flow
- pre-payment of a service
- control over an app that users need
- do users need it
- Does it support future development?
- What tokenomics does it serve?
- hands-on knowledge on crypto-wallets (types, uses, risks)
- crypto-exchanges and crypto-trading options
- types of crypto-assets, their features, and their use cases
- types of networks and their utility
- types of DeFi applications
- non-fungible tokens and the uses
- tokenization opportunities and challenges
What every finance professional needs to learn
Challenges
Proof of Work uses unsustainable amounts of energy
Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/
Usage
| Network | DApps | Dollarvolume |
|---|---|---|
| Ethereum | 3,500 | $40-50B |
| Solana | 100 | $2.5B |
| Binance Smart Chain | 250 | $3B |
| Avalanche | 400 | <$.5B |
| EOS | 300 | <$100M |
| Algorand | 12 | <$20M |
Ethereum Challenge 1: Environment
- Carbon footprint of Switzerland
- Power consumption of Austria
Ethereum Challenge 2: Throughput
Source: Etherscan w re-scaling
Ethereum Challenge 3: State Size
Examples of open research questions
- optimal contract for roll-ups
- roll-up incentives
- transparency and privacy in roll-ups
- role of delayed arbitrage
Hacks, Thefts, and Exploits
Common Reasons: hacks, faulty code, tricking a protocol
Dark side of DEx trading: Miner extractable value
Example of research question in the literature
- optimal design of protocols to prevent MEV
Summary and Outlook
Prediction and Summary
- crypto is the financial market for the borderless digital economy
- many tokens and projects will die, but blockchain is here to stay
- FIs will offer crypto on-ramps and applications which will lead to tokenizations of existing assets
- investors will demand info and advice on types of crypto-assets, their features, and their use cases
- some form of regulation will come but it's not clear what, of whom, and how it will be enforced
- digital representations of money and other assets will spread
- many new research questions in every area of finance will emerge
@financeUTM
andreas.park@rotman.utoronto.ca
slides.com/ap248
sites.google.com/site/parkandreas/
youtube.com/user/andreaspark2812/
What lies ahead?
What is an NFT?
- Nobody wants a finance product
- \(\to\) people want what the product buys them
- Same goes for DeFi!
- to date:
- too much focus on shuffling money around
- still not clear what to do with DeFi
- too much focus on tech not users
- "unique" token
- digital ownership certificate
- ERC-721 standard (also ERC-1155)
Source: Christophe Spaenjers (Hec Paris) NFTs: Modern Masterpieces—Or Money For Nothing?
Boring view of DeFi: do what FI does without FIs
Interesting view: do things that we have not seen
Developments: NFTs bring in entirely new ideas
- Model of active ecosystem-building:
- start with an NFT series
- roadmap with NFT= access to expanding array of products, activities, and experiences.
- Revenue back to brand to support new projects
- \(\to\) value of the NFTs \(\nearrow\)
- But: beware of rug pulls!
- private chat rooms
- graffiti board
- high-end merchandise
- social events incl actual yacht party
- boardwalk-themed metaverse game
Myths, Misconception, and some Truths
Myths, Misconception, and some Truths
- Crypto = Blockchain
- Bitcoin = Ethereum
- Proof of Work = solve hard maths problem
- Bitcoin/Crypto is the choice of criminals
- CBDCs will make crypto irrelevant
- FIs are not needed with crypto
- Crypto tokens have no fundamental value
Understanding the evolution
Evolution
Blockchain 1: A 2022 Defi Primer
By Andreas Park
