Blockchain Technology in Finance: Intro

Instructor: Katya Malinova
Course : F741 Fall 2023

Goals for today

5-minute high-level
- What is blockchain?
- What is cryptocurrency?
What can it do for you and why should we care (DeFi)
Challenges with decentralization?
What is a token? Types of tokens?
Key regulator issues and challenges
Time-permitting: DeFi & "real finance": challenges

The Premise of the
Internet & Blockchain

Peer to Peer Communication

!

?

https://www.youtube.com/watch?v=fs-YpQj88ew

Bill Gates Explains the Internet to Dave (1995) | Letterman

Peer to Peer Communication

Peer to Peer Value

!

?

Sidebar: What is digitize-able value?

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

Peer to Peer Communication

Peer to Peer Value

!

?

What took so long for P2P value?

Peer to Peer Communication

Peer to Peer Value

!

?

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?

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?

Existing value transfer solutions?

Problems/Risks?

POWER CONCENTRATION/MONOPOLY

2-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

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

Why "block" + "chain"?

Transaction

Execution

Consensus Protocol =

a set of rules that determine what kinds of blocks can become part of the chain and become the “truth”.

Source: Cambridge Bitcoin Energy Consumption Index https://cbeci.org/

Proof of work protocol: unsustainable amount of energy

https://www.web3.university/article/the-ethereum-merge

https://carbon-ratings.com/eth-report-2022

Ethereum power usage before the Sept 15, 2022 Merge

https://carbon-ratings.com/eth-report-2022

Where to start for more detail?

https://www.youtube.com/watch?v=_160oMzblY8

Anders Brownworth YouTube video and a demo:

https://andersbrownworth.com/blockchain/blockchain

Ethereum "intro to" articles (with links to further info and to videos):

https://ethereum.org/en/developers/docs/intro-to-ethereum/

Odd Lots Podcast has a fantastic non-technical episode on

the Ethereum Merge!

Why is this idea powerful?

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

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

trading Infrastructure

payments network

Stock Exchange

Clearing House

custodian

beneficial ownership record

seller

buyer

Broker

Problem: usage of capital is constrained by the tech frictions

Application: decentralized trading with automated market makers

New institutions!

passive "shared" liquidity provision
new pricing function

Some background stats on DEcentralized Exchanges (DEX)

Source of savings:

better risk sharing among liquidity providers
better use of capital

Possible transaction cost savings in cash equities: $\approx$ 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 & Flash loans

1. flash-borrow DAI

5. repay DAI

3. receive the collateral (ETH) at a discount

4. convert ETH to DAI

2. liquidate ETH-collaterilized loan with DAI

Loan liquidation opportunity

New tools: flash loan

either all of these execute or none -> arbitrage!
can be used more traditionally -- e.g. to refinance a loan at a better rate

Many automated DeFi products are emerging

https://indexcoop.com/products

https://indexcoop.com/products/defi-pulse-index

Obvious Smart Contract Application: Automate Investment Strategies

"yield aggregator:" push capital where rate of return is highest

Many stories for why tokens are ponzi schemes.

https://www.youtube.com/watch?app=desktop&v=KZYqL79GDXU

Odd Lots: SBF and Matt Levine on How to Make Money in Crypto (podcast, April 25, 2022)

If too pressed for time to listen, start at minute 21:17, or check out:

https://www.bloomberg.com/news/articles/2022-04-25/sam-bankman-fried-described-yield-farming-and-left-matt-levine-stunned

https://defillama.com/fees/uniswap

UNI governance token holders: control rights, but no cash flows

Platforms, Peer-to-Peer, and Decentralization

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?

liquidity mining (LM) = rewards for providing liquidity - worked (?) for Compound

Liquidity Mining & Yield Aggregators

Yield aggregators:

develop strategies to systematically take advantage of token issuance (liquidity mining) programs
like pooling funds to take advantage of banks deposit incentives

liquidity flees quickly after liquidity mining programs end
"mirage" effect: yield aggregators borrow what they deposit

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 Landsgemeinde in the canton of Glarus on 7 May 2006, Switzerland (Wiki)

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

What's a crypto-token and what's special (and positive) 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

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

asset

representation of ownership
pool claims, digital items
example: receipts from UniSwap, Compound, NFTs

Disclaimer: this list in non-exhaustive, new ideas and concepts come up every day!

Tokens by use

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

derivatives

tokens based on other tokens & functions
Example: Synthetix, dYdX

Disclaimer: this list in non-exhaustive, new ideas and concepts come up every day!

Regulatory issues: U.S. test for whether it's a security

Similar regulation in Canada: look up the Pacific Coast Coin test

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?

Why are Blockchains challenging for current regulation?

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
emerged that do all three

tokens are often not intended to be investments!

... and that brought us ...

wash trading
pump-and-dump schemes
Bitfinex-Tether price manipulations
cyber hacks
epic thefts, "rug pulls," and fraud

DeFi for "Real Finance," Stablecoins & why you should care even if you don't

Time-permitting

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

\}

huge demand for continuously available "high quality" money

$\to$ stablecoins

Stablecoins $\to$ Financial stability concerns

currently
- borrowing and lending is balance sheet based
- bank deposits are "stable," long-term
- 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
- stablecoin failure would disrupt every aspect of commerce

Stablecoins & Stability

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

Very mobile liquidity!

Also:

automated strategies (eg yield aggregators)
or deliberate attacks

Stablecoins & Alternatives

Best backing for a stablecoin?
- $\to$ reserves!?
- $\to$ makes a stablecoin issuer a "narrow bank"
Can this be supported?
Is CBDC an viable alternative?
Privacy?
- What rights do you have?

Just in: regulators

https://www.sec.gov/news/sec-videos/office-hours-gary-gensler-staking-a-service

Non-regulatory challenges

Challenge #1 (?): Environment

Most cited problem are for the proof-of-work consensus protocol

https://carbon-ratings.com/eth-report-2022

Usage

Network	DApps	Dollarvolume
Ethereum	3,500	$40-50B
Solana	100	$2.5B
Binance Smart Chain	250	$3B
Avalanche	400	<$.5B
EOS	300	<$100M
Algorand	12	<$20M

Ethereum Challenge 1: Environment

Carbon footprint of Switzerland
Power consumption of Austria

	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

Challenge 2: Throughput

https://ethereum.org/en/developers/docs/scaling/

Active on-going work on solutions:

https://www.youtube.com/watch?v=7pWxCklcNsU

Sharding

Optimistic Rollups

ZK Rollups

Sidechains

	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

Challenge 2: Throughput

Ethereum Challenge 2: Throughput