Andreas Park PRO
Professor of Finance at UofT
Blockchain and Decentralized Finance:
A 2023 Primer
Presenter: Andreas Park
Agenda
- Getting our hands dirty!
- Background:
- Vocabulary & Evolution
- What's DeFi and what's different to TradFi?
- Explain some key DeFi applications
- What do we know about tokens?
- What happened with FTX & Terra and what's the S.E.C. doing?
- Outlook
What is a Blockchain?
What is a Cryptocurrency?
Why is this idea powerful?
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
A blockchain is a
- general purpose
- open access
- value management
- infrastructure
- that is communally run
- create & manage assets
- transfer value
- contingent contracts
- guaranteed execution of sets of commands
- applications
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
trading Infrastructure
payments network
Stock Exchange
Clearing House
custodian
custodian
beneficial ownership record
seller
buyer
Broker
Broker
Application: decentralized trading with automated market makers
AMM Pricing
- Purchase \(q\) of asset
- Deposit cash \(\Delta c (q)\) into liquidity pool, extract \(q\) of shares
- liquidity before trade \(=\) after trade
\[L(a,c)=L(a-q,c+\Delta c)\]
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
Application: Decentralized Borrowing & Lending
borrow
provide collateral
The Flow of Event: Normal Times
The Flow of Event: Collateral Liquidation
Dapp composability ("DeFi LEGOS") & Flash loans
Interest rates: a function of pool usage
threshold usage rate
Some Data
Securities Creation: Tokensets
idea: create new mutual fund like asset
Platforms, Peer-to-Peer, and Decentralization
Philosophy of Peer-to-peer
Traditional Market
two-sided with fixed roles
- consumers \(\leftrightarrow\) producers
- consumers \(\leftrightarrow\) intermediaries \(\leftrightarrow\) producers
Decentralized Market?
value management protocol \(\not=\) market
- blockchain \(=\) application execution \(=\) intermediary
- blockchain-native \(\Rightarrow\) requires platform thinking
- consumers \(=\) producers
Peer-to-peer \(\Rightarrow\) Platforms
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?
it works!
A Consequence of Liquidity Mining: Yield Aggregators
Idea:
- strategy to systematically take advantage of token issuance (liquidity mining) programs
- like pooling funds to take advantage of banks deposit incentives
- liquidity flees quickly
- "mirage" effect: yield aggregators borrow what they deposit
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
A 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
- tokens are often important for the functioning and incentives of platforms
What's a crypto-token and what's special about it?
- a blockchain is a protocol in which
- users have direct control and responsibility over their assets
- users can create codes at will
- \(\rightarrow\) any user can create tokens and applications
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!
An ugly 9 months
From a slow slide to a thorough crash
-75%
-75%
!
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
Recurring Core problem QuadrigaCX:
- QuadrigaCX:
- Gerry Cotton sold people crypto he did not have
- FTX:
- auto-execution of margin calls for all except Alameda
- SBF used customer funds to hide "short" market maker Alameda
Fundamental Problems: Solution sans Regulators?
IN FINANCE TERMS
- hedge = off-setting position
-
here: unhedged/"leverage"
Solution
- prove aggregate positions
- prove assets & liabilities
- asset = liabilities \(\Rightarrow\) solvency
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
- funding
- record-keeping
- instruments
- custody
- advice
- trading
services
needed & provided
- takes care of custody and allows self-custody
- allows instrument creation
- enables record-keeping
- allows circumvention of existing institutions
A general purpose value management infrastructure:
intermediaries
separate institutions
- asset custodians
- broker-dealers
- trading platforms
The blockchain reality:
new institutions
emerged that do all three
tokens are often not intended to be investments!
... and that brought us ...
- wash trading
- pump-and-dump schemes
- Bitfinex-Tether price manipulations
- cyber hacks
- epic thefts, "rug pulls," and fraud
- crypto trading platforms and custody risk
- quibble with CFTC on jurisdiction
- enforcement actions
- "almost all crypto-assets are securities"
Regulators' Focus
MiCA
- whitepaper rule
- platforms as money services businesses
current look: almost all branches of the US government work to make it "go away"
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
- blockchain as an idea will not become uninvented
- there is continuous research & development, including by universities
- when another hype starts, people will want to get their hands on the assets
- blockchains are borderless by design
- "tough" regulation pushes firms outside of jurisdictions
- no regulation can prevent the bankruptcy of an offshore entity
- willing issuers want clear guidance
- but issuers of crypto assets cannot comply with current rules
Final Thoughts
Some Final Thoughts
- blockchain tech won't get uninvented.
- young people and universities keep working on blockchain ideas
- 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
@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?
- People want(ed) crypto assets and they will get their hands on them
- US style differentiation of securities vs commodities etc is neither helpful nor useful
- There is no such thing as "technology-neutral" regulation.
- Some rules from securities regulation simply cannot be implemented with blockchain tech
- Just because someone buys something with an investment motive doesn't mean that they should get all securities protections
Provocative Thoughts
- End of Theory -
Some Developments
- Soulbound tokens, digital ID, privacy zero-knowledge proofs
- improved user experience, e.g., SIM cards with blockchain wallets
- invisible blockchains (used in China for AliPay NFT storage)
Blockchain Infrastructure
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?
- money
- digitally native assets
- claims on resources and property
- identity, personal data
The challenge: how do you ensure digital scarcity?
- traditional approach: unique record-keeper
- problem:
- intermediary necessary for record keeping
- tight supervision of custodian
- no peer-to-peer
- What is the equivalent of TCP/IP for value?
Esade Master of Finance Presentation DeFi RSM 2023
By Andreas Park
