Blockchain Technolgy in Finance: a dive into DeFI

Instructor: Katya Malinova
Course : F741 Winter 2021

Application: issuing and transferring money

A short history of Money

Cryptocurrencies vs USD

Cryptocurrency = money?

Can bitcoin or ether replace "fiat" MONEY?

store of value?

unit of account?

method of exchange?

$\to$ does not require "double coincidence of wants"

$\to$ don't have to price everything relative to each other

$\to$ don't have to spend money immediately upon receiving it

Application: stablecoins

BTC, ETH

fiat: USD, EUR

asset (gold)

fee-backed

Seigniorage

Crypto

Traditional

Algorithmic

Collateral-Backed

Taxonomy of Stablecoins

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 ...

Application: stablecoins

Fiat-backed

A Controversial StableCoin: Tether (USDT)

Link to Forbes

(Link to Medium)

Application: stablecoins

Crypto-backed

unified unit of account: dai

Money

Idea:

create fiat money on chain
mechanism
- a collateralized loan with ETH in escrow
- DAO-managed monetary policy (=creation or destruction of tokens)

Sidebar: what is a DAO?

DAO=decentralized autonomous organization
$\to$ entity without management
governance decided by token holders essentially by vote

user perspective

Maker DAO

1.25 ETH
(1 ETH = $1200)
(Jan 21, 2021)
$\approx$ $1,500

$\vdots$

1,500 DAI
(1 DAI = $1)

formally: this smart contract is a collateralized debt position (CDP)

Smart Contract: "Vault"

user perspective

Maker DAO

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?

Maker DAO

ETH $\nearrow$ $1,600

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?

Maker DAO

ETH $\searrow$ $600

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 $\searrow$ $480

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

user perspective: what happens if the price falls & max loan is exceeded?

Maker DAO

ETH $\searrow$ $480

value of ETH collateral = $600

3 scenarios:

increase the collateral
return 500 DAI & get 1.2 ETH back
the Vault is liquidated by "keeper"

Keeper sells 1.0417 ETH=500 DAI

(Pays off the loan)

Keeper gets an incentive fee

for liquidating the loan,

say, 0.06 ETH

The Vault Holder keeps:

500 DAI
0.093 ETH= 1.2-1.0417-0.06

Maintaining the Peg: Market forces reinforce stability

Maker DAO

if ETH price in $ $\nearrow$
- $\to$ DAI is worth "too much" relative to $
- $\to$ mint more DAI against the existing collateral
- price (DAI) $\searrow$
if ETH price in $ $\searrow$ then:
- DAI is worth "too little" relative to $
- liquidation incentives $\to$ sell ETH & buy (DAI)
- price (DAI) $\nearrow$

There are also formal incentives & mechanisms

Maintaining the Peg: monetary policy

Maker DAO

stability fee
DAI savings rate (DSR)
debt ceiling

Vault holders (=borrowers of DAI) pay "stability fee" (= interest)

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
- stability fee > DSR

total amount of debt (or DAI) outstanding is limited

Sidebar: how are the features of this protocol decided?
$\to$ special "governance" token MKR

Application: asset trading

The Ugly Truth: token trading and token markets are different from securities trading and markets

Investor

Broker

Venue

Settlement

Exchange

Traditional

Wholeseller

Darkpool

Internalizer

Venue

Settlement

Investor

On chain

Crypto

Application: asset trading

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 do you organize DEX trading?

Atomic swaps

How do you organize DEX trading?

Liquidity?

Laissez-faire: Etherdelta or Kyber
- people submit contracts (limit orders) on-chain
- system collects info
- system offers "tools" to trade against standing contracts

Hybrid: 0x
- "dark liquidity"
- off-chain/sidechain purchase/sale agreements
- system matches compatible orders and posts on-chain

Automated market maker (AMM) (Uniswap)
- AMM holds assets on both sides
- offers two-sided quotes ($\to$ always liquid)
- prices adjust continuously to demand/supply shifts

Application: asset trading

DEX Example: Uniswap

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

invariant $k=4\times4=16$

Instantaneous exchange rate:

1 = 1

Contract deposit:

How do you organize DEX trading? EXAMPLE

automated market maker

sell 4 DAI for how many USDC?

\begin{array}{rcl} k&=&\#\text{USDC}\times\#\text{DAI}\\ 16&=&(4-y)\times(4+4)\\ y&=&2 \end{array}

0.5

How do you organize DEX trading? EXAMPLE

automated market maker

invariant $k=100\times100=10,000$

Contract deposit:

Problem: large "slippage" (or price impact)

"Deep liquidity" helps minimize this.

$100\times$

How do you organize DEX trading? EXAMPLE

automated market maker

sell 4 DAI for how many USDC?

\begin{array}{rcl} k&=&\#\text{USDC}\times\#\text{DAI}\\ 10K&=&(100-y)\times(100+4)\\ y&=&3.85 \end{array}

$100\times$

$3.85\times$

$-3.85\times$

0.9625

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 of 30bps $\to$ paid to liquidity providers (pooled)
liquidity providers still face opportunity costs relative to all other assets $\to$ 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

Application: Innovative Financing Tools

What is a token?

Or Future Users

Can be traded right away

May get listed on an exchange

more credibility

Rights to future cashflows from the project

Cumulative Token sales since Jan 2016

Data: coinschedule

$25B total

$21B in 2018

for comparison: total size of

Toronto Stock Exchange: $2,200B
Toronto Venture Exchange: $41B

Some spectacular returns

Source: Tokendata, Jan 23 2021

Also: a real horrow show

Source: Tokendata, Jan 23 2021

Contributions in ETH, USD estimates depend on the price of ETH

Also: a real horrow show

BETSY STARK, ABC News: Some say the [technology] is so
revolutionary that the usual roles for valuing an asset, such as
revenues and earnings, no longer apply.

Source: PBS Documentary DotCon

MIKE LEE, Venture Capitalist: The conclusion we came to,
rightly or wrongly so, was that the [technology] was going to
fundamentally change the way business was run across the
board, in every sector of business.

technology = Internet

time: 1999-2000

When First Mortgage
Network changed the name to Mortgage.com and went on the Net, the
estimated market value jumped from $100 to $800 million.

Why care for tokenomics?

Tokens: a New Financing Tool?

Preliminary (academic) Research insights: What can (utility) tokens finance that traditional securities cannot?

can finance projects that otherwise would find no equity funding

enable network effects and new business opportunities

allows entrepreneurs to extract more surplus

Blockchain Tech Stack: Tokens vs Cryptocurrencies

Infrastructure

reward
and
internal currency

usage fee
or
incentive

usage fee

Service

Application

Tech Stack Layer

Role of Token

cryptocurrency

Token

Key: you cannot collect money from just anybody!

regulatory Issues: Many tokens are securities

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

Blockchain Tokens and Coins as Payments & a Financing Tool?

Breakout rooms' discussion

What are the key new opportunities?

What's missing?/Value of VC and/or traditional intermediaries?

Blockchain Tokens and Coins as Payments: a New Financing Tool?

Since Jan 2016: $31 billion for 1,700+ early start-ups
TMX Venture (successful, since 1999, for junior firms)
- $42 billion market cap (since 1999!)
- In 2018: 52 IPOs, $2.2 billion
Private markets in Ontario: raised $70 billion in 2017

Lessons?

Significant interest in FinTech
Appetite by retail investors for risk/early-stage firms
Possible to raise funds directly from investors
VCs and intermediaries do provide a service
- money does not substitute for business plan/advice
- "wisdom of the crowd" is non-existent (?)

Related: Centralized Solutions

Central Bank-Issued Digital Currencies

Time-permitting, may touch upon these on Jan 27, but most likely will discuss on Feb 03

Questions for the future

What is the economic impact of "tokenizing everything"?

How will it affect investments and investment banking?

Which business opportunities will it enable?

What do tokens and "alternative money" mean for payments?

@katyamalinova

malinovk@mcmaster.ca

slides.com/kmalinova

https://sites.google.com/site/katyamalinova/

L3 F741 DeFi

By Katya Malinova

L3 F741 DeFi

This is the second part of blockchain intro slides -- this one focuses on decentralized finance applications

Katya Malinova PRO

I am an Associate Professor, Mackenzie Investments Chair in Evidence-Based Investment Management at the DeGroote School of Business, McMaster University, Canada.

sites.google.com/site/katyamalinova