Andreas Park PRO
Professor of Finance at UofT
Blockchain and Decentralized Finance:
A 2024 Primer
Presenter: Andreas Park
Agenda
- Background:
- Vocabulary & Evolution
- What's DeFi and what's different to TradFi?
- Explain some key DeFi applications
- Understanding tokens
- asset-linked tokenization
- stablecoins
- crypto-tokens and their role
- Getting your hands dirty!
What is a Cryptocurrency?
Conceptually, what is a blockchain?
What our financial infrastructure looks like
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
payments
stocks, bonds, and options
swaps, CDS, MBS, CDOs
insurance contracts
\(\Rightarrow\) a single common resource
- easy value management
- straightforward transfers & ownership accounting
- new types of contracts and usage of assets
- \(\ldots\)
What would the most efficient financial infrastructure look like?
\(\approx\) 50% is bitcoin (but used to be 70%)
How do you own a blockchain asset? Addresses, Accounts, Wallets, and Public/Private Keys
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
- Self-custody of assets
- Access to financial infrastructure
- Value management layer = common resource
- Platform approach to commerce
What makes blockchain-based finance different from TradFi?
Decentralized Trading
Trading Infrastructure
payments network
Stock Exchange
Clearing House
custodian
custodian
beneficial ownership record
seller
buyer
Broker
Broker
Application: decentralized trading with automated market makers
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
Let's look at some stylized facts
\(\to\) simply connect with MetaMask (or similar wallet)
How does this look in practice?
Broker
Exchange
Internalizer
Wholeseller
Darkpool
Venue
Settlement
Pool-based lending principles
borrow
provide collateral
Application: Pool-based borrowing and lending
Application: Decentralized Borrowing & Lending
Obvious Smart Contract Application: Automate Investment Strategies
idea: create new mutual fund like asset
"yield aggregator:" push capital where rate of return is highest
Flash Loans
5. repay DAI
for loan
with health factor <1
liquidation
opportunity
1. flash-borrow DAI
2. repay loan
with DAI
3. claim
collateral ETH
4. convert ETH to DAI
What roles do tokens play?
- People clearly treat tokens and cryptocurrencies as objects of speculation
- data: authors calculations from TAQ (up to March 2023)
- crypto volume worldwide is larger by factor >4
- Self-custody of assets
- Access to financial infrastructure
- Value management layer = common resource
- Platform approach to commerce
What roles do tokens play?
recall the differences
\(\to\) key feature: no necessary intermediaries
Application 1: decentralized trading with automated market makers
Problems:
- How to get liquidity?
- How do you attract traders?
lesser problem because
- tokens trade elsewhere
- arbitrage creates activity
Common solution: create a reward token! Here's how this works
Step 4: users receive a reward token based on the time that they lock up the "receipt" token
Step 3: users lock up the "receipt" token in a smart contract
Step 2: users contribute liquidity and get a "receipt" token
Step 1: create reward tokens and deposit into a smart contract
borrow
provide collateral
Application: Pool-based borrowing and lending
Application 2: decentralized Borrowing and Lending
Same problems as with trading:
- How to get liquidity?
- How do you attract borrowers?
But: in contrast to trading, here you need both!
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?
Without intermediaries:
platform economics!
incentives for both?
What value do these tokens have?
- Functionality:
- fee levels for AMMs
- decision to deploy on other chains
- key threshold values for lending
- Monetary value
- implicit claims on "protocol" income
- implicit claim on reserve pools
Vampire Attacks and Other Shenanigans
Source: https://finematics.com/vampire-attack-sushiswap-explained/
- Vampire Attack:
- syphon liquidity from a different protocol
- using your own token!!!
- Mechanism:
- deposit in UniSwap, receive LP token
- deposit LP token to Sushi, receive rewards
- liquidate LP token and migrate original liquidity to Sushi = "suck out the blood from UniSwap"
another common trick:
- pump the price of the reward tokens
- \(\Rightarrow\) "yields" often exceed 500%
Application 3: Oracle Nodes Ecosystems
Chainlink
https://market.link/overview
- Function 1: Payment
- payment from decentralized applications for oracle function
- Function 2: enforcement of uptime and honesty
- providers must stake token to participate
- deposit stakes can be slashed
- \(\to\) deposit signal of commitment
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?
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!
Asset Tokenization or
"The Creation of Asset-Linked Tokens"
Tokenization is coming
- this list contains mostly "neglected" assets
- what about very "busy" assets aka equities
- what challenges apply to tokenization?
- what problem are you trying to solve vis-a-vis traditional markets?
- what do we have to worry about with a defi implementation?
- what are the opportunities?
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
Tokenization & DeFi Solutions
- stock=ownership rights
- rights to dividends
- rights to shareholder votes
- How can you retain them in a world where
- tokens can be held indirectly by smart contracts
- ownership attribution is pseudonymous
- Li, Park, Singh, Veneris (2024)
- off-chain registry of accounts
- on-chain data collection
- rights redemption contract
- some of this may require legal and regulatory changes
DEX Accounting is complicated
- issuer whitelist must include NFT position manager account for CL DEX
- \(+\) factory contract (to lookup pools by pairs & fee).
- knowledge of the pool’s invariant functions
- shareholders must report corresponding tokenIds of any CL pool where they hold positions
Some solutions exist
- automated dividend distribution
- will likely exceed gas limits
- homemade dividends (=buy back schemes)
- can't handle other holding rights
- Zhitomirskiy, Schmid, and Walther (Dec 2023)
- can't handle other rights and is not defi-compatible
Tokenization FAQs
- Can we do KYC and restrict transfers?
- Yes one can create whitelists.
- But why? That kills all advantages of defi
- Can we have tradfi involved, defi & KYC?
- Yes. Can use a rollup.
- Case: tokenized gold
- issued on rollup
- allows defi applications and free use within rollup
- asset cannot "leave" the rollup
What is a stablecoin?
digital representation of a unit of a fiat currency on a blockchain
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
pulled from Nick Carter's talk on "Will stablecoins serve or subvert U.S. interests?"
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
Stablecoin use cases
What do central bankers think about stablecoins?
BIS Survey of Central Banks:
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
Run Risks
Stablecoin Run Risks
- Scenario:
- concern about stablecoin backing
\(\to\) mass-redemptions - stablecoin issuer liquidates backing assets
- liquidity crisis in backing assets
- \(\to\) contagion to traditional finance
- concern about stablecoin backing
- Secondary effects
- disruptions would spread across applications, wallets, and functions
- \(\to\) stablecoin failure would disrupt every aspect of digital commerce
- Is this plausibe? The Case of USDC
- backing assets are in the most liquid assets and banks
- limited number of arbitrageurs allows side deals
- but: scale is still very small
The "U.S. President's Working Group on Stablecoins" would essentially make issuers narrow banks (deposits largely backed only by reserves)
Money Laundering and Crime
- Does it provide scale?
- Does it enable new criminal activity?
- Is there substitution from super-visable means? Is it easier and safer to use for criminals than traditional means?
What's special about crypto-crime?
Banned addresses (usually by OFAC order)
criminals don't use USDC - why are we so worried?
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.
"The approximate amounts in USD received by wallets on the TRON blockchain associated with terrorist entities:
- Hamas: $2.3M
- DUBAI Co. for Exchange: $29M
- Palestinian Islamic Jihad: $87M
- Hezbollah: $2.364B"
Source: https://inca.digital/intelligence/crypto-intelligence-alert-tron/inca_digital_crypto_intelligence_alert-TRON.pdf
Reality Part 2: The Stinky Stuff
Central Bank-Issued Digital Currencies
Evolution
2008
2014/5
2019
2020
Possible CBDC architectures
Source: BIS Quarterly Review, March 2020
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
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 |
Taking a step back
- 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
Options 1 a&b: Collateral Backed Stablecoins \(\to\) USDC
- "Cash at Reserve Banks" once was SVB
- Reserve fund = short-date US treasuries & overnight repos
primary market acces: 560+ entities
\(\vdots\)
formally: this smart contract is a collateralized debt position (CDP)
- create fiat money on chain with borrowing
- a collateralized loan with ETH in escrow
The User's Perspective for a DAI Loan
Option 2 (reminder): Assets converted to cash: MakerDAO
Case 1:
stablecoin \(>\$1\)
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
secondary market
LUNA secondary market
Option 3: Algorithmic Stablecoin like UST on Terra
arbitrageur
issuer
exchange UST for newly minted LUNA tokens at the prevailing $ market rate
market
LUNA market
Case 2:
stablecoin \(<\$1\)
Option 3: Algorithmic Stablecoin like UST on Terra
Sadly, we know how this has always ended
UST Stablecoin
LUNA (cryptocurrency of the TERRA network)
But: there is no theoretical result that shows that collapse is inevitable
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
UST, Basis, Neutrino
DAI, FEI
Final Thoughts
Some Final Thoughts
- this presentation only scratches at the surface, there are tens of thousands of people working on blockchain ideas
-
this is not (only) garage band work -- university research plays a key role
- blockchain tech won't get uninvented.
- 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/
Why are Blockchains challenging for current regulation?
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
Illustration of the Challenges: The UniSwap Token
Questions around Regulation & Compliance
- Are regulations as they are because of existing institutional arrangements or
- are institutional arrangements the way they are because of regulations?
- compliance in a borderless world
- efficacy?
- flight to offshore?
- is compliance even possible?
- cost-benefit of compliance for regulators and the regulated
- What is the goal of regulation?
- compliance?
- disappearance?
- investor protection?
- issuer protection?
present vs future
- moving and evolving space: fighting the last war?
- unintended consequences of "future proofing"
Challenge 1: How do you get data onto a blockchain?
The Oracle Problem
<standings: 7,3,8,4,2,1,6,5> + digital signatures
Disagreement?
Majority Vote
1 ETH = $4780
1 ETH = $4789
1 ETH = $4781
DEXes can be used as on-chain price oracles
Time-Weighted Average Price (TWAP)
The Oracle Problem
- Participation incentives?
- rewards, payments...
Oracle nodes form their own ecosystem
- Incentives for honest reporting?
- penalties, collateral...
- Reputation?
- Uptime, correctness, penalty history, collateral amount....
- Fee collection from dAPPs
- Nodes stake LINK
- More LINK staked more jobs taken
staked LINK can be slashed
Chainlink
Same follow-on challenge for builders: how can you fit staking, rewards, and inevitable speculation into securities law?
Challenge 2: the settlement layer has a mind of its own
a
b
c
d
e
f
g
Problem: Public Mempools allow Sandwich (MEV) Attacks
Solutions and Remedies
- Flashbots protocol
- encrypted transactions
- FHE Protocol
A brief look under the hood: the workflow
liquidity pool
blockchain
user
website
router
liquidity pool
blockchain
user
A brief look under the hood: the workflow
aggregator protocol
router
pool 1
blockchain
user
pool 2
multiple
pools
A brief look under the hood: the workflow
back to UniSwap
pool 1
blockchain
user
pool 2
A brief look under the hood: the workflow
back to UniSwap
pool 1
blockchain
user
pool 2
just-in-time
liquidity bots
A brief look under the hood: the workflow
back to UniSwap
pool 1
blockchain
user
pool 2
just-in-time
liquidity bots
in the settlement layer ("MEV")
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?
SUFE Financial Development and Innovation in the New Economy Program - Presentation on DeFi RSM 2024
By Andreas Park
