Andreas Park PRO
Professor of Finance at UofT
Rotman Alumni Weekend April 2023:
A Blockchain, Crypto, and DeFi Primer
Presenter: Andreas Park
Agenda
- My job: to inform
- My perspective: a curious economist
- My goal
- Clarify Vocabulary & Evolution
- Explain some key DeFi applications
- What's DeFi and what's different to TradFi?
- What do we know about tokens?
What is a Cryptocurrency?
Conceptually: What is a Blockchain?
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
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: \(\approx\) 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
Obvious Smart Contract Application: Automate Investment Strategies
idea: create new mutual fund like asset
"yield aggregator:" push capital where rate of return is highest
Platforms, Peer-to-Peer, and Decentralization
Philosophy of Decentralized Markets
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
- BUT: in the aggregate, they still add value
Decentralized Governance
idea: blockchain-based = democracy
Problems to solve:
- What level and what decisions?
- Who gets to vote?
- What institutions?
- Majority rule vs minority rights?
- What's a majority?
- Why democracy?
Firms
- autocracy: CEO takes most decisions with minor restraints
- central body
- Investor = transactional relationship
A Taxonomy of Tokens
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
- 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
- securities regulation is very broad and covers (and is meant to cover) almost everything
- But: crypto-assets and investment contracts are often separated.
- tokens can have many purposes - which one reigns supreme?
Example: ETH- payment token for usage of the network = money or coupon
- can be used for staking income = income generating
- staking is an economic activity
- staking as a service is an investment contract
Some thoughts about crypto-assets as securities
How do you comply?
- crypto-entities have no address or geographic location
- cryptos can be held in self-custody and be used in contracts
- How would an issuer know who owns them?
- How do you get prospectuses to "investors"?
- Smart contracts issue tokens - who would do the reporting?
- Who does the reporting for generally decentral entities?
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!
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)
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?
Path forward
- 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
- jurisdictional battles among regulators have to end
- willing issuers need clear guidance
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?
Rotman Alumni Presentation 2023
By Andreas Park
Rotman Alumni Presentation 2023
A presentation for Rotman Alumni on Blockchain, Crypto, and DeFi
