Andreas Park PRO
Professor of Finance at UofT
Stablecoins, Tokenization, and CBDCs
Instructor: Andreas Park
What is money?
What is money? => THree Key Features
store of value
unit of account
method of exchange
A short history of Money
A short history of Money
A short history of Money
A short history of Money
A short history of Money
What's the relationship of payments and monetary policy?
Payments and Monetary Policy
A
B
\(-\)
0
+
A
B
0
+
\(-\)
Option 1: borrow from BoC
lending rate:
deposit rate:
target rate
target rate\(+\)25bps
target rate\(-\)25bps
Payments and Monetary Policy
A
B
0
+
\(-\)
Option 2: borrow from another bank
target rate
Payments and Monetary Policy
The Impossible Trinity (macroeconomics)
free flow of capital
Control exchange rate
Control interest rate
Basic macroeconomics: you can have TWO out of THREE
Why? The inconvenience of markets ...
Stablecoins
pulled from Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"
BTC, ETH
HQLA: USD, EUR
asset (gold)
fee-backed
Seigniorage
Crypto
Traditional
Algorithmic
Collateral-Backed
Taxonomy of Stablecoins
DEPOSITS
other assets
JPM coin
USDC
USDT
TUSD
DAI, FEI
explicitly backed
implicitly backed
Collateral Backed Stablecoins: USDT & USDC
\(\Rightarrow\) 5% over-collateralized
primary market acces: 6 entities only
Collateral Backed Stablecoins: USDT & USDC
- "Cash at Reserve Banks" once was SVB
- Reserve fund = short-date US treasuries & overnight repos
primary market acces: 560+ entities
What makes a Stablecoin stable?
USD-USDT (6 months)
\(\Rightarrow\) need a primary/reference market mechanism to allow for forces of arbitrage to align prices
- stablecoins are issued
- by a single entity or
- a blockchain-based algorithm (smart contract)
- they trade in a secondary market
- on crypto-exchanges against fiat
- on crypto-exchanges against cryptos
- on-chain against other tokens
- \(\Rightarrow\) stablecoin price fluctuates
Arbitrage when price(stablecoin)>$1
collateralized stablecoin
arbitrageur
issuer/ primary market
secondary market
collateralized stablecoin
arbitrageur
Arbitrage when price(stablecoin)<$1
issuer/ primary market
secondary market
What makes a Stablecoin stable?
What makes a Stablecoin stable?
- stablecoin (SC)
- 1 SC = 1 fiat unit (FU)
- But: stablecoins trade on markets
- 1 SC \(\approx\) 1 FU
- \(\to\) 1 SC \(\lessgtr\) 1FU
- How do we get it "close" all the time?
- Arbitrage mechanism!
- \(\to\) there is an alternative mechanism to exchange SC against FU
in crypto:
fully collateralized
issuer
under-collateralized
smart contract
Case 1: price(1 SC) \(>\) 1 FU \(\to\) SC expensive
collateralized stablecoin
arbitrageur
issuer
market
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
collateralized stablecoin
arbitrageur
issuer
market
every issued token has a corresponding HQLA amount
A thought experiment for a stablecoin
- balance sheet: $3T
- cash: $>60B
Option 1a (existing cash):
- lock up cash in an escrow
- \(\to\) stablecoin is claim on cash
Option 1b (convert cash to digital):
- issue stablecoin in exchange for new cash
- lock up new cash in an escrow
- \(\to\) stablecoin is claim on cash
Option 2 (overcollateralized):
- lock up existing shares in an escrow
- \(\to\) issue stablecoin as a claim on stocks
- over-collateralize
Option 3 (exotic):
- issue stablecoins in exchange for shares
- guarantee fixed conversion of shares against stables at dollar market price
What are Apple's options?
Thought experiment: Apple Inc. wants to issue a stablecoin
MakerDAO's DAI
(or: Apple's Option 2)
user perspective
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)
user perspective
fractional collateral \(\to\) collateralization factor \(=\) 150%
\begin{array}{rcl}
&&\textsf{maximal amount of DAI in \$}\\\\
&=&\frac{\textsf{\$ equivalent of ETH in escrow}}{\textsf{collateralization factor}}\\\\
&=&\frac{1,500}{150\%}=\$1,000
\end{array}
total collateral = $1,500
maximum loan = $1000
overcollateralization = $500
actual loan (example) = $500
buffer = $500
user perspective: what happens if the price of ETH rises?
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
user perspective: what happens if the price of ETH falls?
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
user perspective: what happens if the price falls & max loan is exceeded?
Maker DAO
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
\(\Rightarrow\) triggering of liquidation auction by "keeper"
sell 3.33 ETH=$500=500 DAI
repay $500=500 DAI loan
retain incentive
return remainding ETH to vault owner
Maintaining the Peg: monetary policy
Maker DAO
- stability fee
- DAI savings rate (DSR)
- debt ceiling
borrowers of DAI need to pay interest \(\to\) stability fee
- if too much minting (=too much DAI) then
- \(\to\) interest \(\nearrow\) \(\to\) cost of DAI \(\nearrow\)
- \(\to\) minting \(\searrow\) \(\to\) supply DAI \(\searrow\)
DSR paid on "locked" DAI
- DAI deposited to specific contract (demand \(\nearrow\))
- funded by stability fees
- \(\to\) SF>DSR
total amount of debt (or DAI) outstanding is limited
Sidebar: how is this decided?
\(\to\) special "governance" token MKR
Value locked Oct 27, 2021
Maker DAO
Source: daistats.com (Oct 27, 2021)
Source: daistats.com (Oct 26, 2022)
The March 12, 2020 "BlAck Thursday" Drama
Maker DAO
- some crypto prices dropped more than 50%
- cascading liquidations in leveraging platforms
- network congestion: some liquidations done at near-zero prices
- collateral shortfall in DAI
- MakerDAO sold new DAO tokens to collect collateral
- odd: DAI became riskier but high demand for DAI to trigger liquidations!
PEG stability module (PSM)
Maker DAO
The Problem:
- in extreme bull/bear runs, the peg may no longer work
- example: March 2020
- ETH dropped significantly and suddenly
- a rush occurred to (a) get out of ETH into save assets and (b) to collect DAI to get keeper fee
- upward pressure on price of DAI
The Solution:
- Peg stability module
- swap a given collateral type directly for DAI at a fixed rate (no minting/borrowing)
- like regular vault type with a zero stability fee and a liquidation ratio of 100%
- accessed through a user-facing smart contract containing the relevant swap functions (no ownership, just straight swap)
Note: In May 2021, ETH prices dropped again by >30% but no drama in DAI
The frontier: DAI loans for real-world assets
Maker DAO
Algorithmic Stablecoin: UST on Terra
(or: Apple's Option 3)
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
under-collateralized stablecoin
arbitrageur
issuer
market
- arbitrageur purchases should raise price in market
- BUT:
- will is rise fast enough?
- does the issuer have enough funds or, rather have funds for long enough?
- for fully decentralized algo/smart contract stablecoin: there is no dollar to give!
Case 1: price(1 SC) \(>\) 1 FU \(\to\) SC cheap
arbitrageur
issuer
- for fully decentralized algo/smart contract stablecoin: there is no dollar to give!
The Case of Luna-Terra
exchange LUNA for newly minted UST tokens at the prevailing $ market rate
market
LUNA market
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
arbitrageur
issuer
- for fully decentralized algo/smart contract stablecoin: there is no dollar to give!
The Case of Luna-Terra
exchange SC for newly minted LUNA tokens at the prevailing $ market rate
market
LUNA market
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
DISCUSSION
- backing/collateral is the value of the LUNA/Terra Network
- \(\to\) must have value(Terra)\(\ge\sum\) SC
- when you issue new LUNA tokens
- shift value from current to new owners
- create inflation\(\to\) price(Luna)\(\searrow\)
POTENTIAL PROBLEMS
- value(Terra)\(<\sum\) SC
- could be pre-drop SC
- when SC<FU, LUNA token holders
- know price(LUNA) will drop
- \(\to\) pre-emptive selling
- more LUNA issued
- \(\to\) more inflation
- \(\to\) more price drops
- \(\to\) DEATH SPIRAL!!!
- So far there has never been an algorithmic stablecoin that did not collapse.
- Disclaimer: I am not aware of a mathematical proof that an algo stableconin cannot work.
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
- now let's do the maths carefully:
- price UST: \(p_s\)
- Assume \(p_s<1\)
- Arbitrage mechanism:
- Borrow $
- use $ to buy UST
- Sell UST for LUNA at $ price \(p_l'\)
- sell LUNA token for $$
- Repay $ loan, keep profit
- assumptions
- arbitrageur trades max \(q_s\) so that \(p_s=1\)
- \(q_s\) UST buy for Luna with price \(p_l'\) \[\frac{q_s}{p_l'}~\text{LUNA}\]
- redeemed UST destroyed, LUNA newly minted
- \(\to\) dilution.
- \(\to\) assume MKT anticipated extra quantity of LUNA \(q_s/ p_l'\)
- assume: TERRA network value unaffected
- except: validation costly \(\to\) minimum viable price \(\underline{p}_l\)
- network collapses if \(p_l<\underline{p}_l\)
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
- exchanges these \(q_s\) UST for LUNA at dollar-price for LUNA
- network value not affected:
\[Q_lp_l=(Q_l+q_l)p_l'\] - solve this to get\[p_l'=p_l-\frac{q_s}{Q_l}.\]
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
- define \(Q_d=Q_sp_s\) aggregate UST $-value
- arbitrageur buys \(q_s\) such that\[1=\frac{Q_d+P(q_s)}{Q_s-q_s}\]
- assume AMM pricing (for simplicity): \[q_s=Q_s(1-\sqrt{p_s})\]
- exchanges these \(q_s\) UST for LUNA at dollar-price for LUNA
- network value not affected:
\[Q_lp_l=(Q_l+q_l)p_l'\] - solve this to get\[p_l'=p_l-\frac{q_s}{Q_l}.\]
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
- \(p_l'\) cannot drop below \(\underline{p}_l\)
- Maximum feasible quantity forUST: \[\overline{q}_s=Q_l(p_l-\underline{p}_l)\]
- \(\overline{q}_s=\) collateral value of aggregate LUNA tokens
- \(Q_s\le\overline{q}_s\): UST is fully collateralized
- \(Q_s>\overline{q}_s\) UST is under- collateralized & \(\exists\) price deviation that would cause a collapse of LUNA and UST.
Case 2: price(1 SC) \(<\) 1 FU \(\to\) SC cheap
- Can compute maximal price deviation
- \(q_s\) that restablishes depends on peg-deviation price \(p_s\) and \(\sum\) UST \(=Q_s\)
- minimum price (1-price is max deviation)
\[\underline{p}_s=\left(1- \frac{Q_l}{Q_s}(p_l-\underline{p}_l )\right)^2\]
Stablecoin use cases
What do central bankers think about stablecoins?
BIS Survey of Central Banks:
What do central bankers think about stablecoins?
Stablecoin use cases
- Domestic
- developed world: do things you otherwise can't do
- developing world: everything
- stablecoins as payments compete with existing rails
- factors for adoption are
- price
- convenience
- reach/applications
- interoperability (e.g., credit availability, acceptance)
- International
- move assets faster and cheaper
- do things banks can't/won't do
Source: On-chain Foreign Exchange and Cross-border Payments by Austin Adams, Mary-Catherine Lader, Gordon Liao, David Puth, Xin Wan (2023) [team from UniSwap Labs]
DeFi fees:
- fiat to crypto on ramp: 0%-1%
- exchange fees 1-5bps
- network fee: $0.001-5$
- off-ramp fee: 0%-1%
- total: from close to 0 to 2%+$5
- Canada has 800,000 international students
- admits around 300,000-400,000 annually
- Government of Canada: "We estimate that in 2017 and 2018 respectively, international students in Canada spent $18.4 billion and $22.3 billion on tuition, accommodation, and discretionary spending."
- Most of these funds are transferred from foreign countries to Canada in large sums.
- Students regularly get harrassed by tellers/banks about the source of their funds.
Canada is a country of international students
- To get admitted & get a visa you need to
- make a sizeable deposit
- prove that you have funds for tuition and sustaining your life
- How??? \(\to\) expensive brokers and other shady arrangements
Risks to Financial Stability
Broad Blockchain Risks to Financial Stability
Lending capacity & Monetary transmission
Deposit mobility
AML/CFT/Sanction evasion
Dollarization
Failures/runs
New cyber-risks
Stablecoin Run Risks
Stablecoin Run Risks
- currently
- borrowing and lending is balance sheet based
- Central Bank and Risk Regulators (e.g. OSFI and OCC) effectively ensure fungibility of bank money
- private stablecoins
- would spread across applications, wallets, and functions
- \(\to\) stablecoin failure would disrupt every aspect of commerce
Stablecoin Run Risks
Source: "Stablecoin Runs and the Centralization of Arbitrage," by Ma, Zeng, Zhang, 2023
- existing stablecoins
- issued by firms (Circle, Tether) in a primary market at price \(p_p=\$1\)
- creation/redemption by limited parties (arbitrageurs)
- stability mechanism:
- buy stablecoin from issuer if \(p^s>1\)
- redeem at issuer if \(p^s<1\)
- \(\to\) arbitrageurs are liquidity providers in secondary market
- why run: Dymand-Dybvig-stype framekwork
- issuers' reserves are somewhat illiquid hold
- run occurs if fear that arbitrageurs leave market when issuer stops redemptions
Stablecoin Run Risks (2)
Source: "Stablecoin Runs and the Centralization of Arbitrage," by Ma, Zeng, Zhang, 2023
- key mechanism: limited number of arbitrageurs
- two opposing effects:
- many
- easy to sell
- more efficient pricing
- but: fast depletion!
- few (=harder to redeem and more market power)
- hard to sell
- more price impact in the secondary market
- then: pre-emptive running more expensive
- many
Result: lower concentration can have higher run risk
volatility (USDT)\(>>\)volatility (USDC)
stylized facts reg arbitrageurs
- USDT \(\approx\) 5
- USDC \(\approx\) 500
USDT \(\approx 4\%\)
USDC \(<1\%\)
"haircuts proxy for the discount incurred when illiquid assets are converted into cash at short notice"
Empirical calibration of run risk (dates/months signify important changes in reserve assets):
USDT in March 2022: 3.45%
USDC October 2021: 0.14%
Stablecoins and Deposit Markets
Stablecoins and Deposits
- Circle
- issued $338B
- redeemed $302B
- supported >T$10 transaction volume
- prior to SVB held 20% in deposits
- \(\to\) high movements that are beyond the control of issuer
- \(\to\) not everyone can redeem
- during the SVB crash (on March 9) Circle requested the transfer of about $5B away from SVB
Source: Jeremy Allaire testimony to the U.S. Congress , June 14, 2023 https://www.circle.com/executiveinsights/payment-stablecoins-support-the-dollar-and-u.s.-economic-competitiveness
Collapse of Anchor (as part of the TERRA-Luna debacle)
max TVL:
top 20
max lending:
top 50
current lending:
top 100
Crypto-assets incl. Stablecoins and Deposits
Canadian Banks' Financing with Retail Deposits
BoC analysis (August 2020):
- [banks] are well-positioned to absorb potential temporary negative effects on profitability and liquidity
- Banks[can] absorb the shock under plausible adoption scenarios.
- [No] threat to the stability of the financial system or to banks’ competitiveness in terms of ROE.
- banks will maintain healthy liquidity levels, and liquidity could become a concern only in the most extreme scenario.
Stablecoins and Deposits
- Best backing for a stablecoin?
- \(\to\) reserves!
- \(\to\) makes a stablecoin issuer a "narrow bank"
- What if DeFi applications serve "real" finance?
- DeFi Lending
- DEX trading
Source of savings:
- better risk sharing among liquidity providers
- better use of capital
AMMs applied to equity trading could save \(\approx\) 30% of transaction costs
Source: "Learning from DeFi: Would Automated Market Makers Improve Equity Trading?" working paper, Malinova & Park 2023
- scenario:
- widespread tokenization
- defi applications widely used
- \(\to\) need a lot of stablecoins to support this economy
Automate Investment Strategies for Lending Pool Deposits
"yield aggregator:" push capital where rate of return is highest
Yield Aggregators create very mobile liquidity
Source: "Phantom Liquidity in DeFi Lending", Park and Stinner (2023) working paper
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
Stablecoins and Deposits
- DeFi applications for "real" finance
- DeFi Lending?
- Lending club on blockchain? (incl. personal loans etc)
- pools would be mostly stablecoin-based
- DEX trading?
- tokenized stocks require cash and stock deposits
- on chain FX require stablecoins in multiple currencies
- DeFi Lending?
\}
huge demand for continuously available "high quality" money
Small Open Economy Risks
Currency Competition
Source: "The Coming Battle of Digital Currencies," Will Cong and Simon Mayer, 2022
- paper with CBDCs, private stablecoins, and cryptocurrencies
- dominant, strong, and weak fiat currencies
- assumes CBDCs would transcend brokers
- non-USD, solid fiat currencies benefit from CBDC introduction
- dominant country CBDC (widely available) or stablecoin: weak countries face digital dollarization
- weakest countries benefit from crypto adoption
Findings
Source: "Decrypting new age international capital flows", C. Graf von Luckner, Carmen M. Reinhart, Kenneth Rogoff, JME 2023
"there is already a growing market for using crypto as vehicle currency for transactions in developing economies and emerging markets, especially for international capital flight and evading exchange controls."
Idea:
- Identify Bitcoin trades used for cross-border wealth transfers and payments;
- = trades on LocalBitcoins that are of equal size in short time windows
- crypto vehicle trades in the data set \(\approx \ge\) 11.1%
Weak Fiat vs. Crypto: Some Empirical Evidence
Fig. 5. Example of Bitcoin market expansion coinciding with capital controls in Argentina Source: LocalBitcoins.com API, BlueDollar.net, Authors’ Calculations.
Fig. 2. The World's 25 biggest Crypto Vehicle Channels. Circles: Origin, Triangles: Destination. Line-width: Channel volume as share identified trade volume in Origin Currency Sources: LocalBitcoins.com API, Paxful.com API, Authors’ Calculations.
Cracking the Code: How the US Government Tracks Bitcoin Transactions By YoonJae Chung Seoul International School (2019)
no fungible tokens allowed, but NFTs OK.
Cyberattacks and Hacks
Risk is in every layer of the tech stack!
- Network Layer
- DDoS attacks etc.
- Blockchain Layer
- Sybil attacks
- MEV
- Smart Contract Layer
- Malicious code
- Bug exploits
- Interface Layer
- Oracle attacks
- Malicious plug-ins (e.g., malicious wallet installation etc.)
Cyberattacks and DeFi-Thefts
run by Jump Trading a very sophisticated, tech-savvy HFT firm
\(\Rightarrow\) many threat vectors
Wallet Hacks
- hardware wallet attacks via SIM attacks
- unencrypted data explots
- local device hacks (keylogging, overlay)
- Man-in-the-middle attack (e.g., hacking of exchanges)
- exploits of private key generators
Hacker remotely stole validator private keys
Bridge attack
Hacker minted WETH out of thin air on Solana's contract
Signatures were not verified! Bridge attack....hmmm
Tech Overload: Solana
PS: Bitcoin has never been down, but Ethereum had some major slowdowns
Special Use Case: New Forms of Prudential Regulation without Regulators?
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 Problem for centralized exchanges
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
Might be a model for bank stability?
Money Laundering and Crime
Basic FINTRAC Rules for Money Services Businesses
- Basic rule: for any virtual currency transaction money services businesses need to verify and record the identity of the person involved
- Transactions over $10,000 need to be reported
- lots of smaller rules surrounding suspicious activties
\(\Rightarrow\) the rules are "tight"
Big Picture Concern
- tight KYC and monitoring rules make it hard for criminals to use illicitly obtained funds
- tight rules raise the risk of detection
- tight rules make people's lives harder
\(\to\) trade-offs
- no rules will make it impossible to move illicit funds
- specific concern in the digital world: giving criminals SCALE
Banned addresses (usually by OFAC order)
criminals don't use USDC - why are we so worried?
Tornado cash
August 8, 2022: OFAC sanctions Tornado Cash
Chainalysis Crime Report
extra info:
- 2019: PlusToken Ponzi scheme
- numbers depend on known addresses, e.g., 2021 report listed ~.3% for 2020 and upped to .65 now
The Common View
The Reality
- no evidence that Hamas has received significant volumes of crypto donations.
- full understanding of blockchain analysis and context is needed
- Elliptic: Wall Street Journal [must] correct misinterpretations of the level of crypto fundraising by Hamas.
- in discussions with Senator Warren to ensure parties have a proper appreciation of the complexities and nuances of analyzing these wallets.
Summary on Concerns regarding Stablecoins
back to Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"
Asset Tokenization
Key Institutional Features of Equities
- listed equities are
- securities by definition
- restrictions on who can hold them
- exchange and trading rules
- knowledge of ownership
- reporting requirements
- well-established custody and ownership transfer with regulated roles
- difficult for beneficiary owner to "use" asset other than transfer
- securities by definition
- If held on a blockchain, what challenges arise and what would need to change?
Institutional Differences: Crypto Asset Ownership, Accounts, Wallets, and Self Custody
Smart contract accounts
- controlled by code
- decentralized applications
- tokens
Externally owned accounts
controlled by private keys
private
key
public
key
(seed phrase)
public
address
wallet = software to keep and use private keys
Blockchain Ownership Attribution
- for the blockchain, an asset is always owned by
- externally owned account
- smart contract
- externally owned accounts can be "reached" by, e.g., blockscan
- smart contract ownership is trickier
Institutional Differences: 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
will emerge
Asset Tokenization or
"The Creation of Asset-Linked Tokens"
Tokenization of stocks is nothing new: American Depository Receipts
foreign investor/
issuer
domestic bank with foreign representation
ADR issuing bank handles
- shareholder communications
- dividend payments
- other recording-keeping
Is this a workable model for blockchain- tokenization of existing assets?
foreign representation of domestic bank/ its custodian
domestic depository bank
S.E.C.
registration with form F-4
domestic broker
issues and cancels ADRs
domestic investor
lets investors own and trade ADRs
domestic
market
deposits shares
Blockchain Tokenization has many options
existing investor/
issuer
token issuance platform
investor
wallet
instruct to create tokens
deposits shares
custodian bank
deposits shares
creates tokens and sells to investors
centralized or decentralized
market
S.E.C.
registration
Token Standards
- ERC-20 = fungible token with minimal features such as
- balanceOf: how much does an address own?
- totalSupply: how many is there?
- approve: (contract owner allows token withdrawal)
- transfer: allows a holder to send a token).
- ERC-721 = non-fungible (has meta-data to describe the token; e.g. website URL or data hash)
- ERC-1155 = limited units of non-fungible
- there are other standards that allow e.g.:
- ERC-1726 dividends
- ERC-4626 interest payments
- ERC-1400/1404
- ERC-3643/ERC-621: restricts initial distributions
Some basic facts
Fact 1: Ownership of tokenized asset can be
- a person/legal entity
- a smart contract
Fact 2: By default issuers do not know who owns their tokens
Fact 3: Investors who hold tokens in DeFi smart contracts have fluctuating holdings.
Fact 4: General ownership restrictions are almost impossible to enforce, and transfer restriction would negate advantages of tokenization
Problems that require solving
ADR issuing bank handles
- shareholder communications
- dividend payments
- other recording-keeping
How are these functions performed with crypto-assets?
Fact 2: By default issuers do not know who owns their tokens
- It is possible to determine block-by-block EOA holders
- \(\to\) can send dividends directly
- but not very economical
- One can reach holders via EOA chat functions and disseminate information (e.g., chat.blockscan.com)
- \(\to\) opt-in for communcation
- good practice from DAOs is to lock tokens in contract and then do voting and dividend payments
- can also administer splits/reverse splits
Some remedies for communication and dividends
All this needs a legal framework that adapts to a decentralized, digital world
Problems that require solving
ADR issuing bank handles
- shareholder communications
- dividend payments
- other recording-keeping
Remaining FIs handle
- trading and transfer rule enforcement of ADRs
Fact 4: General ownership restrictions are almost impossible to enforce, and transfer restriction would negate advantages of tokenization
Legal and regulatory frameworks currently rely on intermediaries and are not prepared for self-custody
Broader Implications for the Financial Industry and the Financial System
Asset tokenization would likely create a massive expansion in demand for stablecoins
Business risk for existing FI: super-easy entry
idea: create new mutual fund like asset
Business Risk to FIs: Customers choose what's best for them
"yield aggregator:" push capital where rate of return is highest
Yield Aggregators are very mobile liquidity
Source: "Phantom Liquidity in DeFi Lending", Park and Stinner (2023) working paper
- FIs would lose the role of providing access to the financial infrastructure
- less sticky capital
- new asset managers
- Investors continue to need advice
- breakup of bundled services is tricky
Effects on the IO of Financial Services
- paying for advice is tricky
- losing income sources will affect equity valuations and room to maneuver for FIs in liquidity provision
Last Words
Summary
- From a conceptual and efficiency standpoint, the advantages of tokenization are a no-brainer
- The current legal and regulatory environment needs to adapt
- There are still many tech problems to be solved
- There will be impacts on the movement of money \(\to\) financial stability
Central Bank-Issued Digital Currencies
Evolution
2008
2014/5
2019
2020
Source: CBDCtracker.org
Possible CBDC architectures
Source: BIS Quarterly Review, March 2020
The Year is 2008: what the Toronto a la cart program teaches us about CBDCs
Cautionary tales for central bank innovation
- Finland:
- Avant card failed
- China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
- Mexico:
- QR code pay uptake <5%
(not CBDC)
- QR code pay uptake <5%
what people want
what we got
- a program designed by city departments
- no regard for business owners or customers
- burdensome regulation
- a truck ("cart") designed by committee that did not work
- program essentially died after 2 years
Features of Digital Money
- instantaneous 24/7 payments
- digital = borderless
- money that is compatible with digital applications, digital finance, internet of things etc
- privacy protection
- peer to peer transfers
- transfers of money without the involvement of a commercially interested third party
- non-fee digital payments
fast money
CBDC run by
Central Bank
CBDC on new communually run system
bank-issued stablecoin on public blockchain
|
What? |
||||
|---|---|---|---|---|
| 24/7 instantaneous | ||||
| borderless | ||||
| programmable | ||||
| privacy | ||||
| p2p | ||||
| no commercial 3rd party | ||||
| nominal fee |
Evolution
The State strikes back: CBDCs
CBDC = Central Bank issued Digital Currency
not a cryptocurrency \(\to\) just a "normal" liability on central banks balance sheets
-
BIS Jan 2019: "Proceed with caution"
-
BIS Jan 2020: "Impeding Arrival"
Is it coming?
players (inter alia)
-
China: kinda-sorta running; provinces prep own initiatives
-
U.S.: has bigger problems and is always a last mover
-
UK: preparing
-
Canada: contingency planning (it'll happen within two years)
-
EMU: It's coming (Christine Legarde)
players (inter alia)
What's the problem and what should a CBDC look like?
current problems
future concerns
crib sheet
too slow
too expensive
not flexible
lack of competition
disintermediation
by new players (Libra)
data harvesting
with no way out
ineffectiveness
of monetary policy
demise of the Loonie
two-tiered world in Canada
fast
cheap
flexible/programmable
universally accessible
Why issue a CBDC?
-
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
- the use of bank notes were to continue to decline to a point where Canadians no longer had the option of using them for a wide range of transactions; or
- one or more alternative digital currencies—likely issued by private sector entities—were to become widely used as an alternative to the Canadian dollar as a method of payment, store of value and unit of account.
When would the BoC issue a CBDC?
Contingency Planning for a Central Bank Digital Currency (BoC website)
CBDC: Token vs Accounts
token-based
identification of the object being transferred as a means of payment
account-based
identification of the individual whose account is being debited
example: cash
example: ETH
Should the central bank issue e-money? Kahn, Rivadeneyra, Wong, Bank of Canada working paper 2019
What is "disintermediation"?
two types of money
government:
-
reserves
-
cash
commercial
-
each commercial loan \(\to\) deposit
cash withdrawl
convert commercial money into government money
lowers bank's balance sheet
disintermediation \(=\)
Would a CBDC destabilize the banks?
BoC analysis (August 2020):
- [banks] are well-positioned to absorb potential temporary negative effects on profitability and liquidity
- Banks[can] absorb the shock under plausible adoption scenarios.
- [No] threat to the stability of the financial system or to banks’ competitiveness in terms of ROE.
- banks will maintain healthy liquidity levels, and liquidity could become a concern only in the most extreme scenario.
Are CBDCs desirable?
Discussion Points
- How will you introduce it and run it?
- Go alone?
- Partner with banks?
- What is the business case?
- Why problem do you want to solve?
- Can a CBDC solve the problem?
- Will you solve the problem?
- What is the best-case outcome?
What is the worst?
Discussion Points: how will you introduce and run it? Concerns
- first CBDC (Finland, early 90s) failed for the tiniest of reasons
- you have only one shot to get it right
- are you prepared to be customer-facing (in Canada: 40M+)?
- can you do it?
- what more than money are you offering?
- you bring the government very close to people with AML supervision
go alone
and do self
partner with banks \(=\)
use them for distribution and operation
- why would they support a competitor to their highly profitable payments?
- what does a CBDC do that fast payments cannot? (case may be different in Europe)
The Year is 2008: what the Toronto a la cart program teaches us about CBDCs
Cautionary tales for central bank innovation
- Finland:
- Avant card failed
- China:
- people are unimpressed with the e-Yuan
- trust AliPay/WeChatPay vs. CCP
- Mexico:
- QR code pay uptake <5%
(not CBDC)
- QR code pay uptake <5%
what people want
what we got
- a program designed by city departments
- no regard for business owners or customers
- burdensome regulation
- a truck ("cart") designed by committee that did not work
- program essentially died after 2 years
Chrystia Freeland Justin Trudeau
of all things crypto and digital in Canada
The Canadian Government and the Digital World
from the Budget 2022
- Addressing the Digitalization of Money
- safe and secure financial system
- digitalization of money [...] creates a number of challenges that need to be addressed.
- high-profile examples where digital assets and cryptocurrencies have been used to avoid global sanctions and fund illegal activities.
- promote fair competition, protect the finances of Canadians and our national security.
- legislative review focused on the digitalization of money and maintaining financial sector stability and security.
UK Government: "wider plans to make Britain a global hub for cryptoasset technology and investment."
What has happened in the CBDC space since August?
- Canada related:
- Bank of Canada research: works with MIT
- Toronto Star article for DoF: "significant impact for financial sector"
- BIS Innovation Hub Toronto for North American CBDC work
- Budget 2022: $17M to DoF/BoC for CBDC work over 4 years
- Worldwide (incomplete list)
- US: Executive order to study intro of CBDC
- China: deployment during Olympics
- Project Dunbar (AUS, Malaysia, Singapore, SA)
- Group of Seven report
- Hoover report on China \(\leftrightarrow\) US & CBDCs
What's the future of digital money?
- countries/regions with strong economies and dominant currencies
- countries with strong economies and non-dominant currencies
- countries with weak currencies
- fiat
- CBDC
- private digital money
What's the future of digital money?
- countries/regions with strong economies and dominant currencies
- countries with strong economies and non-dominant currencies
- countries with weak currencies
highest incentive to launch CBDC to gain tech advantage
nip crypto stablecoin in the bud
adopt crypto (likely stablecoin relating to dominant country)
Cong & Meyer 2022: The Coming Battle of Digital Currencies
Which one is Canada?
What digital money?
fast money
real time rails run by chartered banks
CBDC
run by
chartered banks
run by
Bank of Canada
new communually run system
Stablecoin
private firm (e.g. Facebook)
CBDC on public blockchain
chartered bank-issued on public blockchain
Why digital money?
- instantaneous 24/7 payments
- digital = borderless
- money that is compatible with digital applications, digital finance, internet of things etc
- privacy protection
- peer to peer transfers
- transfers of money without the involvement of a commercially interested third party
- non-fee digital payments
fast money
CBDC run by
Bank of Canada
CBDC on new communually run system
bank-issued stablecoin on public blockchain
|
What? |
||||
|---|---|---|---|---|
| 24/7 instantaneous | ||||
| borderless | ||||
| programmable | ||||
| privacy | ||||
| p2p | ||||
| no commercial 3rd party | ||||
| nominal fee |
Bank of Canada specs in 2021
Notes
- Central bank has no obligation to privacy
- CB cannot allow criminals to use money
Components
- Onboarding & KYC
- Transactions processing & AML compliant
- Connection to legacy FIs without FIs
- Must be available to all Canadians
Features
- Privacy protection
- No direct interaction with customers
- Enable innovation in payments market
Hard Problems
- offline payments
- connection to rest of world
- visitors
- minors
- people of low means or low mental capacity
My personal take
very bad policies
governments with good intentions
the stuff of distopian nightmares: tools that bad governments can use to turn on its citizens
Where do CBDCs fall in and under what conditions?
And then there's the economics
- long-and-short of it: two-sided platforms with externalities behave funny
- an increase in competition can reduce welfare
Source: "Regulating Competing Payment Networks", Lulu Wang, Northwestern Kellogg
Quick background:
normal payments infrastructure
And then there's the economics
Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg
simplified version
here: one-sided market
- entrant competes and merchant fees drop
- merchant happy and may lower prices
but the market is two-sided!
Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg
- VISA pays rewards so that customers use their cards
- very few merchants shun VISA
but the market is two-sided!
Source: "Regulating Competing Payment Networks", LuluWang, Northwestern Kellogg
VISA cranks up the rewards
merchant raises prices - for everyone!
benefit of a CBDC as a competing payments tool is unclear
Why should we worry about private money? The Case of Tether
- on April 30, 2019: Tether does not have cash reserves equal to 100% of the outstanding Tethers.
- May 15, 2019 court hearing: Tether did invest in instruments beyond cash, including Bitcoin
Historically: “Tether Platform currencies are 100% backed by actual fiat currency
assets in our reserve account.”
Text
Today: "The Tether Platform is fully reserved when the sum of all tethers in circulation is less than or equal to the value of our reserves."
IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020
vs.
Why does that matter?
- Tether = ‘pushed’
- print an unbacked digital dollar to purchase Bitcoin.
- \(\to\) additional supply of Tether creates unwarranted inflation in Bitcoin price
Text
IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020
vs.
- Tether = ‘pulled’
- driven by legitimate demand from investors who use Tether as a medium of exchange
- \(\to\) the price impact of Tether reflects natural market demand
Text
IS BITCOIN REALLY UN-TETHERED?
JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020
Flow of events
- Tether is authorized
- moved to Bitfinex
- then slowly distributed to other Tether-based exchanges (Poloniex and Bittrex)
- \(\to\) almost no Tether returns to the Tether issuer to be redeemed
- Kraken (major exchange for Tether\(\to\) USD) accounts for only a small proportion of transactions
Figure 1. Aggregate Flow of Tether between Major Addresses
Figure 3. Aggregate Flow of Bitcoin between Major Addresses.
Top Accounts Associated with the Flow of Tether from and Bitcoin to Bitfinex
- three main Tether exchanges, Bitfinex, Poloniex, and Bittrex, have considerable cross-exchange Bitcoin flows
- cross-exchange Bitcoin flows on Bitcoin closely match Tether flows
- one large player has >50% of the exchange of Tether for
- Bitcoin at Bitfinex
- \(\to\) distribution of Tether into market from ONE large player and not many different investors
If Tether is printed independently
of demand and pushed onto the market then ...
- \(\nearrow\) money supply in crypto
- \(\nearrow\) cryptocurrency prices through artificial demand
- if traded strategically, Tether can further impact and manipulate Bitcoin prices
the 1% of hours with the strongest lagged Tether flow are associated with 58.8% of the Bitcoin buy-and-hold return over the period.
Is the Price Effect Economically Important?
the "normal-times" returns
CBDC: Token vs Accounts
A Taxonomy
Bech and Garratt (2017)
- who is the issuer (central bank or other)
- what is its form (electronic or otherwise)
- who can access and/or hold it (universal or not)
- how is it transferred (centralized or decentralized).
Prevailing view: account-based central bank e-money system is unlikely to be the preferred choice of policymakers
Tokens or Accounts?
Prevailing view: account-based central bank e-money system is unlikely to be the preferred choice of policymakers
- expensive to operate
- CB has no comparative advantage for operation
- CB directly competing with commercial bank accounts
- system was feasible even before the advent of DLT
Why not?
Some history on private money
- free banking era in the US:
- "discounts" between different state-chartered banks prior to 1863
- discounts between notes vary with distance to the location of the issuing bank and its risk-taking behaviour
- Canada, between 1817 and 1890:
- commercial bank notes and provincial notes (later Dominion notes) circulated simultaneously
- discounts until the Bank Act of 1890 (insurance scheme for the redemption of notes of failed banks)
- regulation and supervision of financial intermediaries are necessary to control the discounting between alternative means of payments, counterfeiting and manage price stability.
CBDC: Impact of "Global" Money
CBDC: Impact of "Global" Money
Cryptocurrencies, Currency Competition and the Impossible Trinity
Benigno, Schilling, Uhlig (2020)
Old: impossible trinity
New: with free capital and global currency, equalization of national policy interest rates
\(\to\) less of a point of national currency
Platform Economics
Examples of platform markets
gamers
users
“eyeballs”
cardholders
videogame platform
operating system
portals, newspapers, TV
debit & credit cards
game developers
application developers
advertisers
merchants
buyer
platform
seller
Platform pricing
Source: Jean Tirole's Nobel Lecture
Implications for the platform business model
Source: Jean Tirole's Nobel Lecture
- account for what each side can bear
- account for externalities
- \(\to\) skewed pricing
Simple Example: heterosexual clubbing
assumption: people go clubbing to meet the opposite gender
common problem: imbalance of people from each gender
common solution: differential pricing (including free entry) for one side of the market
Regulation?
Question: is it a must-use arrangement or do people have alternatives?
Stablecoins, Tokenization, and CBDCs 2024-25
By Andreas Park
