Blockchain Technolgy in Finance: Intro

Instructor: Katya Malinova
Course : F741 Winter 2021

Agenda for the Next two classes

Where this is coming from, why, and why should you care.
How does it work?
What can it do for finance, and what are obstacles?
Applications:
- Issuing and transferring money
- Asset trading
- Innovative lending
- Innovative financing tools
Related developments:
- Libra
- Central-bank issued digital currencies

Where this is coming from, why, and why should you care.

What's wrong with the traditional world of finance?

cheap tech, high prices?

Illustration of Infrastructure Frictions: money transfers

Version 1: They use the same bank

Change ledger entry locally

Version 2: They use different banks but the banks have a direct relationship

Alice's bank transfers from Alice's account to Bob's bank's account

Bob's bank transfers from its account to Bob's account

Version 3: They use different banks that have no direct relationship

Alice's bank transfers from Alice's account to its own account

Bob's bank transfers from its account to Bob's account

Central Bank

Central bank transfers from Alice's bank's account to Bob's bank's account

International transfers

Alice's bank transfers from Alice's account to its own account

Bob's bank transfers from its account to Bob's account

use the Swift network of correspondent banks

Source: Wendy Rotenberg via Andreas Park's slides

Bottom Line

very complex

many parties

lots of frictions and points of failure

very expensive

Would we design market this way if we were to start "from scratch" today?

Where this is coming from, why, and why should you care.

Start from scratch. Crazy thought: a single ledger?

"silos" &

painful

transaction

reconciliation

"joint ,single system"

Why should you care? Isn't this too distant of a world?

The world of finance is evolving as we speak!

Existing solutions

Problems?

Risky side effects of "Tech First" solutions
POWER CONCENTRATION/MONOPOLY

why should you care? Because The world is changing!

old days: silos

today: cloud computing

cloud data centers are a worldwide affair

why should you care? Because The world is changing!

January 04, 2021

The U.S. Office of the Comptroller of the Currency (“OCC”) published an interpretive letter that permits them to custody cryptocurrencies.

Quoting from Forbes: "A bank may use stablecoins (cryptocurrencies designed to minimize the price volatility) to facilitate payment transactions for customers.

In doing so, a bank may issue stablecoins, exchange stablecoins for fiat currency, as well as validate, store, and record payments transactions by serving as a node on a blockchain."

why should you care? Because The world is changing!

Source: https://www.forbes.com/sites/haileylennon/2021/01/04/occ-regulator-implements-groundbreaking-cryptocurrency-guidance-for-banks-and-the-future-of-payments

Nokia's market shares for devices:

2007: 49.4%
2012: 3%

why should you care? Because ... History!

Paid-for vs. valued

Keyboard
Security
Being businessy
Cool and cutting edge
Being Canadian
Independence from desk

What did they pay for?

What do people value?

Mobile email

Brand name
Easy access to branch
Great product range
Fair prices
Great advice
Latest tech
Friendly tellers

Safe-keeping of assets

As banks move data into "the cloud," do we need the banks?

Generic Bank

Why should you care? Blackberry vs generic bank

Key Insight: Open Platforms provide value

What took place of blackberry?

decentralized finance

provision of financial services without the necessary involvement of a traditional financial intermediary

(bank, broker-dealer, insurance corporation)

Why should you care?

$\Rightarrow$ it's growing and it's coming

disclaimer: compared to existing markets this is still a tiny amount

Source: https://defipulse.com

disclaimer: compared to existing markets this is still a tiny amount

How does it all work and why?

Distributed Ledger/Blockchain Technology

"joint, single system" "shared resource" "common infrastructure"
Features:
- secure storage of information and transfer of value
- guaranteed execution of code
Promise
- open platform
- global reach
- frictionless finance

From our PollEv: why opt for traditional FIs?

How do we establish trust in commerce?

trustworthy People

long-term Relationships

reputation

contract law

institutions

How do we get trust in an open system with anonymity?

What's needed for trust in anonymous deals?

Authority

Do you have the item?

Do you have power over it?

Tool: "key" cryptography

What's needed for trust in anonymous deals?

Authority

Execution

Can we agree that it happened?

Tool:
consensus algorithm

What's needed for trust in anonymous deals?

Authority

Execution

Continuity

Immutability and Continuity

Are the records immutable?

restricted permissions

really difficult to hack

Authority

Tool: "key" cryptography

Simplest case: symmetric encryption:
public key P = private key S

Small detour: sending a encrypted message

Pb

Sb

Pb

Sb

Small detour: sending a encrypted message

Modern encryption: asymmetric encryption
public key $P_b$, private key $S_b$

Alice sends Bob a message and the signature provides proof that this message is from her

What we really need: digital signatures

Sa

Pa

Execution

Security

Demo [optional]

Anders Brownworth has an excellent interactive web demo that illustrates the concepts discussed above in a bit less abstract way. He also explains the relation between "hashing" and "mining", and a few other tech terms (e.g., a "nonce") in plain English.

You can watch his YouTube of the demo here:

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

Once you have seen the video, you can try hashing and mining yourself here:

https://andersbrownworth.com/blockchain/hash

He also has a demo on digital signatures. Everything is accessible from here:

https://andersbrownworth.com/blockchain/

Security

Potential problem: double-spending

Cryptography
$\Rightarrow$ signature cannot be hacked

B3

B1

B2

B4

B5

Contains transaction from Alice to Bob

Can Alice rewrite history?

Immutability

B3

B1

B2

B4

B5

B6

Where to add a new block $B_7$?

What if you add it to $B_3$?
- future block $B_8$ more likely to be added to $B_6$
- $\to$ lose "coinbase" reward
$\to$ add to $B_6$

Detour: Longest chain rule

Equilibrium for "the longest chain"? - Yes!

"Blockchain Mining Games" by Kiayias,Koutsoupias, Kyropoulouz, and Tselekounis, Proceedings of the 2016 ACM Conference on Economics and Computation, 2016
"The blockchain folk theorem" by Biais, Bisière, Bouvard, and Casamatta, RFS 2018

Note:

accidental "forks" can happen, in particular in fast chains (because of system latencies)
$\to$ need several block confirmations to accept as transaction as settled

B7

B3

B1

B2

B4

B5

be faster
or: be able to block confirmations

B8

B7

B9

B10

B6

Contains transaction from Alice to Bob

Alice wants to undo the transaction by rewriting history with B6

Selfish Mining Attack

How?

$\to$
create predictability of mining

$\to$
have 51% of mining
(= confirmation) power

Back of the envelope calculation (based on 2018)

hashrate: 25,000,000 TH/s
best GPUs have 2.5GH/s per card=0.0025 TH/s
=> need 25,000,000 x 400 x 0.5 = 5,000,000,000 GPUs
1 GPU costs around $200
=>Cost = $1,000,000,000,000
Note from 2020: this cost has only gone up

NB: there is a slightly more subtle view of selfish mining in which the miner creates a block but holds it back to keep mining exclusively on a part of the chain. Sapirshtein, Sompolinsky, and Zohar (2015) show that 23.21% of mining power is sufficient for such an attack

Selfish Mining Attack

What can it for finance, what are problems and obstacles?

One more application:
a stock trade

Alice wants to sell ABX

Bob wants to buy ABX

sell order

buy order

Clearing House

Stock Exchange

Broker

3rd party tech

custodian

record beneficial ownership

central bank for payment

With Blockchain: single ledger for money and securities

0xA69958C146C18C1A015FDFdC85DF20Ee1BB312Bc

0x91C44E74EbF75bAA81A45dC589443194d2EBa84B

0xA65D00Eda4eEB020754C18e021b1bF4E66C9Ed90

Detour: Ethereum

blockchain 1.0
first solution to double spending
clunky, slow, expensive
huge following and computing power

vs

blockchain 2.0
smart contract platform
highly flexible
foundation for many private initiatives

"Let me just say how impressed I am with Ethereum...If Bitcoin is email ––a one-trick pony, so to speak, but obviously revolutionary–– Ethereum goes far beyond that; it's more like the Internet...The whole idea of DeFi really is, number one, it’s obviously revolutionary, and I think at the end of the day could lead to a massive disintermediation of the financial system and the traditional players."

Heath P. Tarbert, CFTC Chairman, October 2020

blockchain Use cases

Think of (or at least google) blockchain use cases and Let's chat about these in Lecture!

Usage of blockchain in financial industry

Areas of applications

moving value (remittances)

digital money: real-time settlement, reduced reserves

tokenization of assets

automization of contract payments

securitization

systems and infrastructure reorganization

digital identity

new forms of financial contracts, assets, and forms of financing

Obstacles?

Business Challenges

What Changes in Business Models can Blockchain Technology bring?

What does blockchain do?

peer to peer value transfers

self-powered platforms

contract execution

disintermediation

Who do you dis-intermediate, and then who is your customer?

issuer

investor

broker-dealer

The Business challenge of dis-intermediation

investment advisor

(Tech) Obstacles?

July 2019: Nakamoto consensus consumes energy on par with Switzerland
No connection between energy burned and economic value created

Proof of work uses unsustainable amount of energy

Reality Check: Capacity

	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, larger block size possible, but there are limits
microtransactions, IoT, and other smart contract use cases place very high demands

Scalability projects for Ethereum

Ethereum blocks have no size limit
but: gas limit imposes computation limit and thus transaction limit
note: in contrast to Bitcoin, Ethererum always announced that it would eliminate proof-of-work eventually

Root Problem

Side Channels:
- Keep two-party interactions off the main chain and use chain only for terminal settlement
Sharding
- instead of storing all info on all nodes, break up the blockchain into shards
- $\to$ hard problem!

Solutions

https://blog.stephantual.com/what-are-state-channels-32a81f7accab

Many Other Solutions in the works

Bitcoin blockchain: "proof-of work" $+$ only the longest chain is viable (lots of energy wasted!)
Different consensus protocols (loosely: to obtain agreement)
- Conflux blockchain: "proof-of-work" $+$ a directed acyclic graph (DAG)
  - think "parallel processing"
  - $\to$ 4,000 transaction per second
- Avalanche consensus (loosely: repeated voting by random subsamples of "validators")
- Other ways to compete for the "right to add the block"
  - "proof-of-stake": prob of winning $\propto$ staked wealth
    - issues remain ....