Andreas Park PRO
Professor of Finance at UofT
Instructor: Andreas Park
Rotman – Master in Financial Risk Management
Financial Innovation
5-minute version:
What is a blockchain?
blockchain=
an infrastructure for digital resource transfers
5-minute version:
What is a cryptocurrency?
cryptocurrency =
internal payment mechanism to pay for operation of a blockchain
5-minute version:
What is Decentralized Finance?
decentralized finance =
provision of financial services without the necessary involvement of a traditional financial intermediary based on blockchain technology
in practice: new financial infrastructure that will be a common resource
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
\(\vdots\)
Source: Harvey, Ramachandran, and Santoro (2020)
Silos vs Common Infrastructures
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
How does it all work and why?
How do we get trust in an open system with anonymity?
A deep dive into the "How?"
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
Evolution
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
Challenges
Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/
Root Problem
Solutions
https://blog.stephantual.com/what-are-state-channels-32a81f7accab
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
going back to Budish (2018)
Serial Chain
Conflux Chain
In Conflux, withholding a block leads to greater anti-cone size
Intuition: Anticone = blocks created without properly referencing others blocks in its vicinity
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
Private Sector Solutions
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
Partnerships
"new financial infrastructure"
(now called Diem btw)
issued by a consortium of firms (e.g., Facebook, Stripe, Lyft) and not-for-profits (Creative Destruction Lab)
two types of coin: single-currency stablecoins and multi-currency stablecoin, fully backed by reserves
idea is conceptually similar to IMF Special Drawing Rights (pegged to USD, EUR, YEN, GBP, YUAN)
in Libra, this coin is a composite, not separate asset
not "pegged", but will fluctuate relative to any other currency (a bit like an ETF)
eventually transition to a permissionless system.
Problem: perimeter control - can unknown participants take control of the system and remove key compliance provisions?
\(\to\) not happening
Modeled after mutually owned stock exchanges
Expanding membership with competition for slots
hope: replicate key economic properties of a permissionless system through an open, transparent, and competitive market for network services and governance.
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
Enter BigTech
cellphone data from 2018 (NewZoo), inflation from 2020 (World Population Review)
Evolution
DIEM = "new financial infrastructure"
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
Lay the groundwork for the next step of the digital evolution: the "Metaverse"
5-minute version:
Finance, Metaverse, and Non-Fungible Tokens
metaverse =
marriage of the digital and physical world
sale price: $69,000,000
What is an NFT?
Why bother with an NFT?
Metaverse application
Related Development: Central Bank-Issued Digital Currencies
Evolution
CBDCs
Source: CBDCTracker.org
Source: BIS Quarterly Review, March 2020
BoC analysis (August 2020):
Would a CBDC improve the efficiency of its currency function?
Would CBDC improve the efficiency and safety of both retail and large-value payment systems?
Is CBDC an appropriate policy response to payment innovations such as privately issued e-money and digital currency to achieve its monetary policy goals and to implement policies promoting financial stability?
"Central Bank Digital Currencies: A Framework for Assessing Why and How " Fung and Hallaburda 2016, BoC Working Paper
Contingency Planning for a Central Bank Digital Currency (BoC website)
Risks and open problems
By Andreas Park
This slide desk is the intro for the MFRM2020 RSM6313 Blockchain segment of the Financial Innovation course.