Blockchain Technolgy in Finance: DeFi Intro and Crypto Trading

A quick recap

blockchain=

an infrastructure for digital resource transfers

software protocols that allow multiple parties to operate under shared assumptions and data

without trusting each other.

Updates are packaged into “blocks” and are “chained” together cryptographically to allow an audit of the prior history

cryptocurrency = 

internal payment mechanism to pay for operation of a blockchain

Consensus Protocol =

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

Transaction

Execution

Proof of work protocol: unsustainable amount of energy

Ethereum power usage before the Sept 15, 2022 Merge

Why is this idea powerful?

trading Infrastructure

Application: decentralized trading with automated market makers

Sources 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

Who controls the Projects? Decentralized Autonomous organizations

Application: Decentralized Borrowing & Lending

The Flow of Event: Normal Times

Dapp composability & Flash loans

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

Many automated DeFi products are emerging

Obvious Smart Contract Application: Automate Investment  Strategies

Crypto Trading

Centralized Trading

Issues and concerns with CEX trading

• No shortage of drama!
• A short list of issues
  1. expensive arbitrage
  2. price manipulation
  3. volume manipulation
  4. security risk
  5. Google "Lazarus Group"
  6. Are they unlicensed securities exchanges?

Costly Arbitrage

BTC/USD

ask: 7,600 

bid: 7,550

BTC/USD

ask: 7,500 

bid: 7,450

Crypto Wash Trading, Lin William Cong, Xi Li, Ke Tang, Yang Yang

• systematic tests:
  • robust statistical and behavioral patterns in trading to detect fake transactions on 29 cryptocurrency exchanges.
  • Regulated exchanges are OK
  • unregulated exchanges: rampant manipulations
  • wash trading on each unregulated exchange:  
    • on average over 70% of the reported volume
    • improve exchange ranking
    • temporarily distort prices

Volume Manipulation

Cryptocurrency Pump-and-Dump Schemes
Tao Li, Donghwa Shin, and Baolian Wang, 2020

Price Manipulation: Pump & Dump

IS BITCOIN REALLY UN-TETHERED? JOHN M. GRIFFIN and AMIN SHAMS
Journal of Finance 2020

vs.

Price Manipulation: Pumping Bitcoin

Price Manipulation: Pumping Bitcoin

Security Risk

The FTX Implosion

Recurring Core problem

• QuadrigaCX (Jan/Feb 2019) (OSC report):
  • Co-founder and CEO Gerry Cotten sold people crypto he did not have
  • "like a Ponzi scheme"
  • => Clients collectively lost $169 million

• FTX (Nov 2022) (according to the CFTC allegations):
  • SBF controls both FTX.com and Alameda Research
  • "features in the code underlying the FTX trading platform that allowed Alameda to maintain an essentially unlimited line of credit on FTX"
  • Allowed Alameda research to bypass the auto-liquidation risk-management process
  • => $8 billion of customer funds siphoned via Alameda 

In a regulatory vaccum re: custody

Decentralized Trading

First approaches: de-centralized limit order book

Decentralized Exchanges (DEX)

decentralized exchange

Key Components

Idea:

• create a way to exchange items on-chain
• fully decentralized
• \(\to\) no single controlling entity, or location, everything runs with smart contracts

How does it look?

automated market maker

Application: decentralized trading with automated market makers

New institutions!

• passive "shared" liquidity provision
• new pricing function

AMM Pricing

• AMMs require liquidity deposits
• Deposits:
  • \(a\) units of an asset (e.g. a stock)
  • \(c\) units of cash

Key Components

automated market makers Pricing Function

• remove \(Q\) of one token
• must add \(P(Q)\) of other token 
• so that liquidity stays invariant \[L(X,Y)=L(X-Q,Y+P(Q))\]
• Common rule: constant product \[X\cdot Y=(X-Q)\cdot (Y+P(Q))\]

How do you organize DEX trading?

automated market maker

Price mechanism:

• risk-neutral "invariance" pricing
• at price, contract (AMM) is indifferent between buying and selling
• \(X=\) contract balance of asset \(A\)
• \(Y=\) contract balance of asset \(B\)
• \(k=\) invariance factor
• key relation \(k=X\times\ Y\)

Prices

• when you want to sell \(x\le X\) you receive \(y\) that maintains invariance. 

How do you organize DEX trading? EXAMPLE

automated market maker

How do you organize DEX trading? EXAMPLE

automated market maker

sell 4 DAI for how many USDC?

How do you organize DEX trading? EXAMPLE

automated market maker

Problem: large "slippage" (or price impact)

"Deep liquidity" helps minimize this.

How do you organize DEX trading? EXAMPLE

automated market maker

sell 4 DAI for how many USDC?

\(100\times\)

\(100\times\)

How do you organize DEX trading? EXAMPLE

automated market maker

​\(\to\) the more money is in the contracts, the lower the price impact

• Increase the deposit to 10,000 DAI & USDC:
  • \(k=10,000\times10,000=100,000,000\)
  • \(~\to\) for \(4\) DAI you get \(10,000-100,000,000/10,004=3.998\) USDC

How do you organize DEX trading? other mechanisms

automated market maker

• anyone can become a liquidity provider when supplying both sides of a pair
  • can also establish a new pair
  • including creating a brand-new token \(\to\) establish a starting price!
     
• trades carry a fee  \(\to\) paid to liquidity providers (pooled)
   
• liquidity providers face adverse selection and opportunity costs relative to all other assets \(\to\) fee income must be sufficient

superannoying feature

automated market maker

• front-running

  • transactions enter mem-pool

  • \(\to\) all visible there

  • arbitrageur make instant-swap trade at higher gas price

    • \(\to\) trade instead of original trade

    • "fix" (not a proper solution): set a max slippage (a range of prices that willing to trade at)

    • Uniswap V3

DEX: Quick Recap

Decentralized trading using automated market makers (AMM)

Liquidity Pool

Quiz: Quick Recap

Consider a DEX (decentralized exchange) that prices securities according to the constant product rule discussed in lecture. The initial deposits in the liquidity pool are 200 ETH and 300,000 USDC. You want to buy ETH. 

Note: buy ETH = sell USDC

After you buy 1 ETH in exchange for y USDC, the pool will have

• 200-1 = 199 ETH 
• 300,000 + y USDC

\(\Rightarrow 200 \times 300,000= (300,000 + y) \times (200-1) \)

\(\to y = 1,508\)

Quiz: Quick Recap

After you buy 10 ETH and sell y USDC, the pool will have

• 200-10 = 190 ETH 
• 300,000 + y USDC

\(\Rightarrow 200 \times 300,000= (300,000 + y) \times (200-10) \)

\(\to y = 15,789\)  -- cost of 10 ETH!

\(\to 1,578.9\) per 1 ETH

Some facts about DEXes

automated market maker

• anyone can become a liquidity provider when supplying both sides of a pair
  • can also establish a new pair
  • including creating a brand-new token \(\to\) establish a starting price!
     
• trades carry a fee  \(\to\) paid to liquidity providers (pooled)
   
• liquidity providers face adverse selection and opportunity costs relative to all other assets \(\to\) fee income must be sufficient

superannoying feature

automated market maker

• front-running

  • transactions enter mem-pool

  • \(\to\) all visible there

  • arbitrageur make instant-swap trade at higher gas price

    • \(\to\) trade instead of original trade

    • "fix" (not a proper solution): set a max slippage (a range of prices that willing to trade at)

    • Uniswap V3

Transaction Processing in DeFi

Transaction Visualization

A Simple Overview

a

b

c

d

e

f

g

The reality is more complicated

Consequence 1: Extract Value from Users

The "dark side": MEV = maximum (formally: miner) extractable value

The charts are for pre-merge, see https://transparency.flashbots.net for post-merge stats

Consequence 2: Excess Gas Prices ("Priority Gas Auctions")

• may raise costs for all users without economic benefit
• wastes blockspace
• slows down processing

One resolution:

Flashbots Protocol

Idea of Flashbots

• separate user roles
  • builders/seekers
  • relay
  • miners/validators
• eliminate public mempool
• reserve top of blockspace for privately submitted transactions

Flashbots does not prevent MEV!

• "democratize" the access
• the structure helps prevent gas auctions

Illustration

Transactions Send to Searchers

NB: the relay is a security measure: it has high capacity and can distinguish garbage from real transactions

Bundles come to Miners

NB: miners could still manipulate, front-run etc, but Flashbots monitors them and would cut them off if they misbehave

Is it used?

81% of validators have signed on with Flashbots (>880,000 total)

Does Flashbots Prevent MEV?

• Flashbots "democratizes" MEV
• prevents priority gas auctions

Flashbot 3.0 Transaction Privacy

• under development (as of 2023)
• Idea: 
  • submit encrypted transactions
  • block building based on gas but not content
  • decryption only occurs at processing
• But: very tricky problem in a trustless world