Andreas Park PRO
Professor of Finance at UofT
Instructor: Andreas Park
Date: March 24, 2021
2020-21 Rotman – MBA
Financial Innovation
Where this is coming from, why, and why should you care.
provision of financial services without the necessary involvement of a traditional financial intermediary
(bank, broker-dealer, insurance corporation)
\(\Rightarrow\) it's growing and it's coming
disclaimer: compared to existing markets this is still a tiny amount
old days: silos
today: cloud computing
cloud data centers are a worldwide affair
Change ledger entry locally
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
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
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
Source: Wendy Rotenberg's Payments lecture
very complex
many parties
lots of frictions and points of failure
very expensive
\(t\)
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\(x\)
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\(x\)
\(t,t,x\)
\(t,t,x\)
\(t,t,t\)
\(x\)
\(y\)
\(z\)
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\(x,y.z\)
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Equilibrium
Blockchain requirement
= 00000xd4we...
= 00000xd4we...
= 00000xd4we...
consensus is reached if hash starts with right number of leading zeros
Contains transaction from Bob to Alice
Question: Can Bob rewrite history?
Where to add a new block B7?
Contains transaction from Bob to Alice
Bob wants to undo the transaction by rewriting history with B6
Bob's objective
What does it take?
How does Proof of Work prevent this?
Back of the envelope calculation
Double spend attack prevention
Basic idea of competitive equilibrium
aggregate mining cost = aggregate reward
Double spending attack
condition that prevents it
(Chiu & Koeppl RFS 2018)
How does it all work and why?
How do we get trust in an open system with anonymity?
Cryptography: only Sue can spend her money
Simplest case: symmetric encryption:
public key P = private key S
Pb
Sb
Pb
Sb
Modern encryption: asymmetric encryption
public key \(P_b\), private key \(S_b\)
Alice wants to send Bob a message and provide proof that its her.
Sa
Pa
Pa
Problem: double-spending
How can we trust that
Cryptography
\(\Rightarrow\) signature cannot be hacked
Contains transaction from Alice to Bob
Question: Can Alice rewrite history?
Where to add a new block \(B_7\)?
Equilibrium for "the longest chain"? - Yes!
"The blockchain folk theorem" by Biais, Bisière, Bouvard, and Casamatta, RFS 2018
Note:
Contains transaction from Bob to Alice
Bob wants to undo the transaction by rewriting history with B6
How?
\(\to\)
create predictability of mining
\(\to\)
have 51% of mining
(= confirmation) power
NB: there is a slightly more subtle view of selfish mining in which the miner creates a block but holds it back to keep mining exclusively on a part of the chain. Sapirshtein, Sompolinsky, and Zohar (2015) show that 23.21% of mining power is sufficient for such an attack
related model: Budish (2018)
basic economics:
expected gain of mining \(\ge\) cost of mining
\(\Rightarrow\) probability of winning \(\times\) block reward \(\ge\) cost
\(\to\) holds for all miners
\(\to\) in equilibrium: aggregate cost of mining \(=\) aggregate benefit
related model: Budish (2018)
\(\to\) cost of attack: \(t\cdot A\cdot c\cdot N\)
total benefit of attack
\(\to\) for unattractive attack: cost \(>\) benefit
means amounts above \(\mathbb{V}\) cannot be secured
Double spend attack prevention
Basic idea of competitive equilibrium
aggregate mining cost = aggregate reward
Double spend - selfish mining attack
condition that prevents it
(Chiu & Koeppl RFS 2018)
G
G
Garrat & van Oordt (WP 2020)
Garrat & van Oordt (WP 2020)
drop in exchange rate S
=loss
What can it for finance, what are problems and obstacles?
Sue wants to sell ABX
Bob wants to buy ABX
sell order
buy order
Clearing House
Stock Exchange
Broker
Broker
3rd party tech
custodian
custodian
record beneficial ownership
central bank for payment
vs
"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
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
Conflux: Consensus with TreeGraph
•Blocks are organized in a directed acyclic graph (DAG)
•No concurrent blocks are discarded, leading to higher throughput
Transaction Processing
Disclaimer: token design strongly influenced by yours truly
Goes life on October 29, 8 a.m.
Root Problem
Solutions
https://blog.stephantual.com/what-are-state-channels-32a81f7accab
Where to add a new block B7?
My personal problem: I have not yet seen a convincing theoretical model of PoS
economic result: Fahad Saleh (2021) Review of Financial Studies, "Blockchain Without Waste: Proof-of-Stake" shows that PoS is an equilibrium
current state:
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
Who gets to update?
Can a higher body prevent
transactions?
Can the past be altered?
consensus
immutability
censorship resistence
open to anyone
no one can be excluded
past cannot be changed
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
Application: Issuing and transferring money
store of value?
unit of account?
method of exchange?
\(\to\) does not require "double coincidence of wants"
\(\to\) don't have to price everything relative to each other
\(\to\) don't have to spend money immediately upon receiving it
store of value?
unit of account?
method of exchange?
funding figures from Nov 2018; source: blockchain.com
Idea:
Sidebar: what is a DAO?
4 ETH
(1 ETH = $375)
(Oct 15, 2020)
\(\approx\) $1,500
\(\vdots\)
1,500 DAI
(1 DAI = $1)
formally: this smart contract is a collateralized debt position (CDP)
fractional collateral \(\to\) collateralization factor \(=\) 150%
total collateral = $1,500
maximum loan = $1000
overcollateralization = $500
actual loan (example) = $500
buffer = $500
ETH \(\nearrow\) $500
value of ETH collateral = $2,000
maximum loan = $2,000/150%=$1,333
total collateral = $2,000
maximum loan = $1,333
overcollateralization = $667
actual loan (example) = $500
buffer = $500
overcollateralization = $667
new loan capacity= $333
ETH \(\searrow\) $187.5
value of ETH collateral = $750
maximum loan = $750/150%=$500
total collateral = $750
maximum loan = $500
overcollateralization = $250
actual loan (example) = $500
buffer = $0
for reference: former value of collateral
ETH \(\searrow\) $150
value of ETH collateral = $600
maximum loan = $600/150%=$400
total collateral = $600
maximum loan = $400
required overcollateralization = $200
actual loan (example) = $500
buffer = -$100
for reference: former value of collateral
\(\Rightarrow\) liquidation possible by "keeper"
sell 3.33 ETH=$500=500 DAI
repay $500=500 DAI loan
retain incentive
return ETH remainder to pool
\(\Rightarrow\) all relies on behavioral assumptions
\(\Rightarrow\) But: there are also real incentives & mechanisms
borrowers of DAI need to pay interest \(\to\) stability fee
DSR paid on "locked" DAI
total amount of debt (or DAI) outstanding is limited
Sidebar: how is this decided?
\(\to\) special "governance" token MKR
Application: asset trading
Investor
Broker
Venue
Settlement
Exchange
Wholeseller
Darkpool
Internalizer
Venue
Settlement
Investor
On chain
Idea:
Price mechanism:
Prices
invariant \(k=4\times4=16\)
Instantaneous exchange rate:
1 = 1
Contract deposit:
sell 4 DAI for USDC
what price will therefore be quoted?
how many USDC?
Problem: large "slippage" (or price impact)
establish and sell a new token
front-running
transactions enter mem-pool
\(\to\) all visible there
arbitrageur make instant-swap trade at higher gas price
\(\to\) trade instead of original trade
\(to\) reverse to gain slippage from earlier trader
take three pairs (ignore that BTC is not directly on Ethereum)
BTC-DAI
ETH-BTC
ETH-DAI
\(\to\) simply connect with MetaMask (or similar wallet)
Application: Innovative Lending
Fundamentally, what does a bank do?
And how is this done?
on blockchain
Example 1
Example 2
Example 3
borrowing and lending rates compounded per block
100%
fraction of supplied that's been borrowed
base rate
borrow rate
common theme in DeFi: jumping between dApps
Source: Harvey, Ramachandran, and Santoro (2020)
Application: Innovative Financing Tools
Data: coinschedule
for comparison: total size of
Toronto Stock Exchange: $2,200B
Toronto Venture Exchange: $41B
can finance projects that otherwise would find no debt or equity funding
enable network effects and new business opportunities
allows entrepreneurs to extract more surplus
can finance projects that otherwise would find no debt or equity funding
Source: Tokendata
Source: Satis Group LLC
Source: Morgan Stanley (Nov 2018) “Update: Bitcoin, Cryptocurrencies and Blockchain”
Source: Tokendata
Lessons?
Technology
Legal/Regulation
Economic functions
interoperability
cybersecurity and privacy
functionality
scalability
smart contract features and verification
space constraints
interoperability
scalability
space constraints:
Does the law have to change to accommodate new tech? If so, how? What's dated, what's not?
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?
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?
Related Development: Libra
Partnerships
"new financial infrastructure"
My prediction: Libra Network will go live in the Spring of 2021
issued by a consortium of firms (e.g., Facebook, Mastercard) and not for profits (Creative Destruction Lab)
each coin will be backed by a basket of SIX fiat currencies
idea is conceptually similar to IMF Special Drawing Rights (pegged to USD, EUR, YEN, GBP, YUAN)
Would you use Libra/Money issue by Tech Firm?
If we ask explicitly for Facebook vs Tech Firm
Scaled to yes/maybe/no. About 20% say: "Need more info"
Source: Will Libra Succeed? Results of a Global Randomized Survey Experiment; by Danielle Goldfarb and yours truly
They have ZERO interest in becoming a financial institution/bank
\(\rightarrow\) no expertise
\(\rightarrow\) competitive market
\(\rightarrow\) one of the most regulated business environments
They are trying to deal with frictions that impede their business
They aim to collect data which will vastly improve their business
Related Development: Central Bank-Issued Digital Currencies
Source: BIS Quarterly Review, March 2020
BoC analysis (August 2020):
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/
By Andreas Park
This is the slide deck that I use for a quick introduction in John Hull's course RSM2321 (Financial Innovation).