Andreas Park PRO
Professor of Finance at UofT
HashLinked Databases and Consensus
Instructors: Andreas Park & Zissis Poulos
Rotman – MBA
Silos vs Common Infrastructures
Illustration of Infrastructure Frictions: money transfers
Version 1: They use the same bank
Change ledger entry locally
Version 2: They use different banks but the banks have a direct relationship
Sue's bank transfers from Sue's account to Bob's bank's account
Bob's bank transfers from its account to Bob's account
Version 3: They use different banks that have no direct relationship
Sue's bank transfers from Sue's account to its own account
Bob's bank transfers from its account to Bob's account
Central Bank
Central bank transfers from Sue's bank's account to Bob's bank's account
International transfers
Sue's bank transfers from Sue's account to its own account
Bob's bank transfers from its account to Bob's account
use the Swift network of correspondent banks
Bottom Line
very complex
many parties
lots of frictions and points of failure
very expensive
Crazy thought: Wouldn't it be nice if there was a single ledger?
Existing solutions
Problem:
power concentration/Monopoly
Distributed Ledger/Blockchain Technology
- A "joint, single system"
- Features:
- secure storage of information and transfer of value
- guaranteed execution of code
- Promise
- open platform
- global reach
- frictionless finance
How does it all work and why?
How do we establish trust in commerce?
trustworthy People
long-term Relationships
reputation
contract law
institutions
What's needed for trust in anonymous deals?
Authority
Execution
Continuity
Authority
Do you have the item?
Do you have power over it?
Tool: "key" cryptography
Execution
Can we agree that it happened?
Tool:
consensus algorithm
Security and Continuity
Are the records immutable?
restricted permissions
really difficult to hack
premise of blockchain
no trusted parties needed
everything
in code
open to
anyone
platform or network
commerce thrives
How?
A deep dive into the "How?"
Cryptography: only Sue can spend her money
Authority
Execution
Problem: double-spending
How can we trust that
- sale happened and
- $$ only spent once?
Execution
Security
B3
B1
B2
B4
B5
Contains transaction from Sue to Bob
Question: Can Sue rewrite history?
immutability
No! Because: Economics!
Incentive to support longest Chain
B3
B1
B2
B4
B5
B6
Where to add a new block B7?
- Add to B3?
- => people after still more likely to add to B6
- lose "coinbase" reward
Altering the past?
B3
B1
B2
B4
B5
- needs to be faster than anyone after who adds to B5 and build a longer chain
- or needs to be able to mine repeatedly
B8
B7
B9
B10
B6
Contains transaction from Sue to Bob
Sue wants to undo the transaction by rewriting history with B6
Sue's objective
- Wants to undo this trade and cheat Bob by building alternative chain from B6
What does it take?
- needs to be predictably able to add several blocks to the chain without interference, or
- needs to be faster than anyone after who adds to B5 and build a longer chain, or
- needs to ability to reject new blocks that are added to B5 .
How does Proof of Work prevent this?
- mining success is random subject to resources spend:
- computers/GPUs
- electricity
- you need faster/more computers than 51% of the network
- current network power: 150million tera-hashes per second (blockchain.info)
Back of the envelope calculation
- hashrate: 150,000,000 TH/s
- best hardware (ASIC) has 110TH/s per unit
- => need 150,000,000 / 110 x 0.5 = 682,000 ASICs
- 1 ASIC costs around $10,000 (conservative)
- =>Cost = $6,820,000,000
- But it doesn't end here...Power consumption at 4.5GW
- => enough to power 1M homes in the US
Economic Analysis, Part II
Double spend attack prevention
- Validation rewards are taken as given, but they are crucial in
- determining incentives to participate,
- to support the chain, and
- to expense electricity and computing power
Basic idea of competitive equilibrium
aggregate mining cost = aggregate reward
Double spending attack
- expense resources but:
- win N block rewards until "confirmation" block
- ability to double-spend
condition that prevents it
(Chiu & Koeppl RFS 2018)
\text{mining reward} \times (N+1)N > \text{double spend amount}
How do you agree though that something happened, or, what is consensus?
How can we reach consensus? The Byzantine Generals' problem
How can we reach consensus? The Byzantine Generals' problem
Blockchain proof of work establishes consensus
Byzantine Generals' Problem
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Byzantine Generals' Problem
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Byzantine Generals' Problem
Equilibrium
- generals pick majority message
- successful consensus as long as no more than 1/3 cheats
Blockchain requirement
- reach Byzantine Fault Tolerant consensus
- trick: messages are hard to forge
Byzantine Generals' Problem
Proof of Work Protocol
A Byzantine Fault Tolerant Algorithm
This Hash starts with a pre-specified number of zeros!
Blockchain BFT
= 00000xd4we...
= 00000xd4we...
= 00000xd4we...
consensus is reached if hash starts with right number of leading zeros
PoW does two things
- selects a leader
- makes messages hard to forge
Blockchain BFT
Proof-of-Stake
Proof of X
Proof of Stake (PoS) - What is the goal?
- Energy efficiency
- No need to commit extreme compute power to solve puzzles for leader election (PoW)
- Centralization Risk
- Can validate using simpler hardware -> more nodes can participate to validate network
- Economic cost of attacks
- Explicit penalties for misbehaviour (vs. PoW)
Validation and leader election
random
32 ETH
Validation and leader election
random
random
random
Committee 1
Committee 2
random
Block formation
Committee 1
Committee 2
...
Committee 32
attest
attest
Slot 1
Slot 2
Slot 32
...
12 seconds
Finality!
...
checkpoint
...
vote
vote
When final?
2/3 of stake has voted
Security
What do we need from validators?
- Participation
- Honesty
if "lazy"
misses out on rewards
if dishonest
Security
What is dishonest?
- Propose multiple blocks for single slot
- Contradictory attestations
TLDR
Performing a 51% attack still possible but "almost equivalent to having your entire mining farm burn down while you are doing it" -Zamfir
Other malicious behaviour
- Long-range attack
- Short range reorgs (can be bad for DeFi)
- etc.
What about forks??
Still possible
- Need agreement on what the canonical chain is
- Longest-chain rule not ideal. Why?
B3
B1
B2
B4
Protocol Rule
"The canonical chain is the one with greatest weight of attestations in its history"
PoS vs PoW
https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/
PoS vs PoW Economics
Basics:
validators receive:
- coinbase rewards
- "tips" = fees attached to transactions
- NB: since London fork fees have two parts:
- manatory (>0 needed for code processing) => gets burned
- tips => fees to validators
- coinbase rewards are inflationary/dillution
- shifts chain value from everyone to validator
PoS vs PoW Economics of Coinbase Rewards
-
PoW:
- coinbase reward go to outside party for performing a service
- proportional to resources committed
-
PoS:
- fees go to existing coin holders for "community service"
- proportional to stake
PoS Economics of Coinbase Rewards
Question: do the rich get richer?
- No
- same idea as in investment: wealth shares in the economy grow proportional to risk-taking
- Here: wealth shares are a Martingale
- convergence to distribution that mimics the initial distribution
- mathematical concept: Polya's Urn
Intution
- Two validators A, B with 20%/80% of coins
- Assume
- 1,000,000 at the begining of the year
- 1,000,000 issued during the year
- Ownership at the beginning of year
- A owns 200,000 coins
- B owns 800,000 coins
- A gets selected 20% of the time, B 80%
- => A earns ~200,000 coins
- => B earns ~800,000 coins
- Ownership at the beginning of year
- A owns 400,000 coins = 20%
- B owns 1,600,000 coins = 80%
PoS Other Questions
- Is PoS an equilibrium?
- Yes: Saleh RFS 2019
- Is verification an equilibrium?
- Tricky!
- Biais et al (WP 2022)
- If everyone verifies, there is no incentive to verify! => Why spend the resources?
- But: can construct a mechanism such that only valid blocks are produced.
- Requires making validators pivotal
- Are higher staking rewards always better?
- John, Rivera, Saleh (WP 2022): not necessarily, can make long-term investment less attractive
- Is scaling a problem?
- limited capacity: validators earn more fees
- increasing capacity
- under PoW: lowers fees and reduces incentives for miners => security \(\searrow\)
- under PoS: increases demand for blockchain => value of chain => security \(\nearrow\)
What can it for finance, what are problems and obstacles?
Evolution
- blockchain 1.0
- first solution to double spending
- clunky, slow, expensive
- huge following and computing power
vs
- blockchain 2.0
- smart contract platform
- highly flexible
- foundation for many private initiatives
"Let me just say how impressed I am with Ethereum...If Bitcoin is email ––a one-trick pony, so to speak, but obviously revolutionary–– Ethereum goes far beyond that; it's more like the Internet...The whole idea of DeFi really is, number one, it’s obviously revolutionary, and I think at the end of the day could lead to a massive disintermediation of the financial system and the traditional players."
Heath P. Tarbert, CFTC Chairman, October 2020
cryptocurrency =
internal payment mechanism to pay for operation of a blockchain
With Blockchain: single ledger for money and securities
0xA69958C146C18C1A015FDFdC85DF20Ee1BB312Bc
0x91C44E74EbF75bAA81A45dC589443194d2EBa84B
0xA65D00Eda4eEB020754C18e021b1bF4E66C9Ed90
Usage of blockchain in financial industry
Areas of applications
moving value (remittances)
digital money: real-time settlement, reduced reserves
tokenization of assets
automization of contract payments
securitization
systems and infrastructure reorganization
digital identity
new forms of financial contracts, assets, and forms of financing
What Changes in Business Models can Blockchain Technology bring?
What does blockchain do?
peer to peer value transfers
self-powered platforms
contract execution
disintermediation
Who do you dis-intermediate, and then who is your customer?
issuer
investor
broker-dealer
The Business challenge of dis-intermediation
investment advisor
Private Sector Solutions
Private vs. public
some key questions
Who gets to update?
Can a higher body prevent
transactions?
Can the past be altered?
consensus
immutability
censorship resistence
Public Blockchains provide
Main private blockchain systems
Features of Private vs. public blockchains
open to anyone
no one can be excluded
past cannot be changed
Public Blockchains
private Blockchains
high visibility of transactions
open-access eco-system
slow governance
privacy only at a cost
joint control and governance
straightforward KYC and AML
tech support
transaction secrecy simpler
rely on corporate development
compliance with law (reversion)
can keep competition out
Enter BigTech
cellphone data from 2018 (NewZoo), inflation from 2020 (World Population Review)
Evolution
DIEM = "new financial infrastructure"
Why does BigTech enter the finance game?
They have ZERO interest in becoming a financial institution/bank
\(\rightarrow\) no expertise
\(\rightarrow\) competitive market
\(\rightarrow\) one of the most regulated business environments
My take
They are trying to deal with frictions that impede their business
They aim to collect data which will vastly improve their business
Lay the groundwork for the next step of the digital evolution: the "Metaverse"
Key Challenges for the blockchain Community for 2019
Technology
Legal/Regulation
Economic functions
What is the right governance structure for systems?
How should we design tokens as contracts?
How do platform payment means interact with outside world
How much do we have to pay operators to maintain the chain?
Key Economic Questions for Blockchain Design
Key Technology Questions for Blockchain Design
interoperability
cybersecurity and privacy
functionality
scalability
smart contract features and verification
space constraints
Solution projects to Key Technology Questions
interoperability
scalability
space constraints:
Does the law have to change to accommodate new tech? If so, how? What's dated, what's not?
Key Legal Questions for Blockchain Design
Legal setup of a platform: what rules can, should, and must a platform establish? What regulations are necessary?
How can token design and the law be married?
Questions for the future
What is the economic impact of "tokenizing everything"?
How will it affect investments and investment banking?
Which business opportunities will it enable?
What do tokens and "alternative money" mean for payments?
quick comparison
FinTech vs. Defi
FinTech
DeFi
- more user-friendly UX
- more customer-oriented
- less squeezing/rent-extraction
- more competive services
- more innovative services
- currently: horribly user-unfriendly
- "blowing up the banks"
- fundamental re-thinking of financial services
- lots of scams, cowboy-attitude towards laws
innovation vs. salesmanship
main focus
Conclusion and final thoughts
blockchain is a transformative technology, but won't be used in practice overnight
many conceptual and technological challenges remain, but there are already various areas of application
legal, regulatory, and competitive changes are needed and then the opportunities are endless ...
it will open up the banking world further, foster international competition, and change how we pay and exchange value
My view: business development will happen in private/semi-public space; strong increase in recent activity; no more testing but re-engineering of processes.
@financeUTM
andreas.park@rotman.utoronto.ca
slides.com/ap248
sites.google.com/site/parkandreas/
youtube.com/user/andreaspark2812/
BlockchainTech: Hash-linked Databases and Consensus Protocols
By Andreas Park
BlockchainTech: Hash-linked Databases and Consensus Protocols
This is the slide deck that I use for a quick introduction to the Decentralized Finance class.
