Blockchain and DeFi Intro Lecture 2024-5

Blockchain and Decentralized Finance:
The 2024-25 Intro Lecture

Presenter: Andreas Park

What is a Blockchain?

What is a Cryptocurrency?

Conceptually, what is a blockchain?

What our financial infrastructure looks like

payments

stocks, bonds, and options

swaps, CDS, MBS, CDOs

insurance contracts

payments

stocks, bonds, and options

swaps, CDS, MBS, CDOs

insurance contracts

$\Rightarrow$ a single common resource

easy value management
straightforward transfers & ownership accounting
new types of contracts and usage of assets
$\ldots$

What would the most efficient financial infrastructure look like?

$\approx$ 50% is bitcoin (but used to be 70%)

How do you own a blockchain asset? 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

Self-custody of assets
Access to financial infrastructure
Value management layer = common resource
Platform approach to commerce

What makes blockchain-based finance different from TradFi?

Decentralized Trading

Trading Infrastructure

payments network

Stock Exchange

Clearing House

custodian

beneficial ownership record

seller

buyer

Broker

Application: decentralized trading with automated market makers

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

Pool-based lending principles

borrow

provide collateral

Application: Pool-based borrowing and lending

Obvious Smart Contract Application: Automate Investment Strategies

idea: create new mutual fund like asset

"yield aggregator:" push capital where rate of return is highest

Flash Loans

5. repay DAI

for loan
with health factor <1

liquidation
opportunity

1. flash-borrow DAI

2. repay loan
with DAI

3. claim
collateral ETH

4. convert ETH to DAI

What roles do tokens play?

People clearly treat tokens and cryptocurrencies as objects of speculation

data: authors calculations from TAQ (up to March 2023)
crypto volume worldwide is larger by factor >4

Self-custody of assets
Access to financial infrastructure
Value management layer = common resource
Platform approach to commerce

What roles do tokens play?

recall the differences

$\to$ key feature: no necessary intermediaries

Application 1: decentralized trading with automated market makers

Problems:

How to get liquidity?
How do you attract traders?

lesser problem because

tokens trade elsewhere
arbitrage creates activity

Common solution: create a reward token! Here's how this works

Step 4: users receive a reward token based on the time that they lock up the "receipt" token

Step 3: users lock up the "receipt" token in a smart contract

Step 2: users contribute liquidity and get a "receipt" token

Step 1: create reward tokens and deposit into a smart contract

borrow

provide collateral

Application: Pool-based borrowing and lending

Application 2: decentralized Borrowing and Lending

Same problems as with trading:

How to get liquidity?
How do you attract borrowers?

But: in contrast to trading, here you need both!

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?

Without intermediaries:
platform economics!

incentives for both?

Asset Tokenization or
"The Creation of Asset-Linked Tokens"

Tokenization is coming

this list contains mostly "neglected" assets
what about very "busy" assets aka equities
- what challenges apply to tokenization?
- what problem are you trying to solve vis-a-vis traditional markets?
- what do we have to worry about with a defi implementation?
- what are the opportunities?

What is a stablecoin?

digital representation of a unit of a fiat currency on a blockchain

pulled from Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"

Collateral Backed Stablecoins: USDT & USDC

$\Rightarrow$ 5% over-collateralized

primary market acces: 6 entities only

Collateral Backed Stablecoins: USDT & USDC

"Cash at Reserve Banks" once was SVB
Reserve fund = short-date US treasuries & overnight repos

primary market acces: 560+ entities

What makes a Stablecoin stable?

USD-USDT (6 months)

$\Rightarrow$ need a primary/reference market mechanism to allow for forces of arbitrage to align prices

stablecoins are issued
- by a single entity or
- a blockchain-based algorithm (smart contract)

they trade in a secondary market
- on crypto-exchanges against fiat
- on crypto-exchanges against cryptos
- on-chain against other tokens
$\Rightarrow$ stablecoin price fluctuates

Stablecoin use cases

What do central bankers think about stablecoins?

BIS Survey of Central Banks:

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

Challenges

Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/

Challenge 1: Energy Consumption

Ethereum Challenge 1: Environment

Carbon footprint of Switzerland
Power consumption of Austria

problem solved

	transactions per second	T per 12 hours (business day)
Bitcoin	7	302,400
Ethereum	30	1,296,000
Algorand	2000	86,400,000
Conflux	4000	172,800,000
Athereum	5000	216,000,000
Payments Canada ACSS	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

Tweaks: lighting network (BTC) or side chains, SegWit, blocksize possible, but there are limits
microtransactions, IoT, and other smart contract use cases place very high demands

Ethereum Challenge 2: Throughput

Source: Etherscan w re-scaling

Ethereum Throughput Solution: L2s/Rollups

Ethereum Challenge 3: State Size

Source: Ycharts

Money Laundering and Crime

Does it provide scale?
Does it enable new criminal activity?
Is there substitution from super-visable means? Is it easier and safer to use for criminals than traditional means?

What's special about crypto-crime?

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

Central Bank-Issued Digital Currencies

Evolution

2008

2014/5

2019

2020

The Year is 2008: what the Toronto a la cart program teaches us about CBDCs

Cautionary tales for central bank innovation

Finland:
- Avant card failed
China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
Mexico:
- QR code pay uptake <5%
  (not CBDC)

what people want

what we got

a program designed by city departments
no regard for business owners or customers
burdensome regulation
a truck ("cart") designed by committee that did not work
program essentially died after 2 years

Features of Digital Money

instantaneous 24/7 payments
digital = borderless
money that is compatible with digital applications, digital finance, internet of things etc
privacy protection
peer to peer transfers
transfers of money without the involvement of a commercially interested third party
non-fee digital payments

fast money

CBDC run by
Central Bank

CBDC on new communually run system

bank-issued stablecoin on public blockchain

What?
24/7 instantaneous
borderless
programmable
privacy
p2p
no commercial 3rd party
nominal fee

Final Thoughts

Some Final Thoughts

this presentation only scratches at the surface, there are tens of thousands of people working on blockchain ideas
this is not (only) garage band work -- university research plays a key role
blockchain tech won't get uninvented.
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

Why are Blockchains challenging for current regulation?

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

Illustration of the Challenges: The UniSwap Token

Questions around Regulation & Compliance

Are regulations as they are because of existing institutional arrangements or
are institutional arrangements the way they are because of regulations?

compliance in a borderless world
- efficacy?
- flight to offshore?
- is compliance even possible?
- cost-benefit of compliance for regulators and the regulated