Brawl at the Gates: How Distributed Ledger Technology is - - PowerPoint PPT Presentation

Brawl at the Gates: How Distributed Ledger Technology is Transforming the Financial Services Sector

Mieszko Mazur

IESEG School of Management m.mazur@ieseg.fr

CFA Institute Talk at TOBAM Paris 11 October 2019

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Disclaimer All references made to various commercial and non-commercial brands during this talk are for illustration purposes only I am excited about the topic and I hope I can transmit some of my excitement to you, however, it should not be seen as an investment advice

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My background

Ph.D. degree from Tilburg University (Netherlands) Currently associate professor at IESEG School of Management (France) Director of the Master’s of Finance CFA University Affiliated Program at IESEG Areas of interest: fintech (cryptocurrencies, blockchains, smart contracts), corporate finance, corporate governance Ad-hoc consultant for the finance industry Link to the working paper which is the basis for today’s seminar

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Part I: Introduction

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Bitcoin system (not blockchain) as a genuine breakthrough innovation

Satoshi Nakamoto (2008) white paper

download

Allows for the secure transfer of value between a sender and a recipient without the intermediary and no counterparty risk Currently - in every economy in the world - transfer of value is overseen by the intermediary (clearing house, central bank, bank for international settlements, notary public, etc.) The process is therefore slow and costly Bitcoin cannot be hacked (banks and credit cards can) In Bitcoin system value and ownership travels in the same channel (in opposite directions) Bitcoin solves the double-spend problem (long-standing problem in the arena of cryptography).The double-spend problem was a serious impediment in the introduction of the Internet money since the inception of the commercial Internet.

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Bitcoin combines several moving parts

Blockchain (type of digital ledger) Common ledger shared among all transacting parties (there is only one unique ledger in that system) There exist different types of digital ledgers which are not used by Bitcoin, e.g., DAG (Directed Acyclic Graph) Proof-of-Work (consensus mechanism) Consensus mechanism is effectively a governance mechanism defining the balance of power among participating entities Other consensus mechanisms include Proof-of-Stake or Delegated-Proof-of-Stake, etc. SHA-256 (Secure Hash Algorithm) by National Security Agency (NSA) The above (and many others) were not developed by Satoshi Nakamoto

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Well-known brands accepting bitcoin as of May 2019

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Bitcoin can trigger strong emotions...

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Famous Bitcoin quotes by well-known individuals

Bitcoin is evil [Paul Krugman] Bitcoin ought to be outlawed [Joseph Stiglitz] Bitcoin is a fraud that will blow up [Jamie Dimon] Bitcoin is a rat poison squared [Warren Buffett] Bitcoin is mother of all scams [Nouriel Roubini] Bitcoin just shows you how much demand for money laundering there is in the world [Laurence Fink] I would short Bitcoin if I could [Bill Gates on May 7, 2018]

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You don’t need Bitcoin to launder money. You can do it a ”legal way” at a bank

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Part II: Bitcoin as a new category of investible asset with unique properties

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Current state of the Bitcoin system

Bitcoin is a first sussessful commercial project that uses blockchain Oldest, most secure, and valuable The largest computer network in the world Currently in many jurisdictions Bitcoin is trusted more than the sovereign money, both as store of value and medium of exchange (Venezuela, Zimbabwe, Argentina, Turkey). Thus, Bitcoin is money If USD and EUR are not available in the market, people tend to choose BTC over tens of other world fiat currencies Thus, BTC brings economic liberty to places where people live under tyranny or limited freedoms Bitcoin is not easily programmable and has non-functional governance (175k lines of code) E.g., developers cancelled SegWit2x in November 2017 However, in August 2019 Bitcoin developers announced Miniscript (=language for writing smart contract on Bitcoin)

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Ethereum as a second generation blockchain

Ethereum tries to solve some of the Bitcoin’s imperfections Built-in programming language for writing smart contracts ERC20 as most popular smart contract to date (= fundraiser) Most of the existing listed cryptocurrencies are ERC20 tokens (digital assets without their own native blockchain). Revolutionized crypto space Creating a token is accessible to everyone

Create a token

System went live in July 2015. 68% of the coins were pre-mined. Proof-of-Work consensus mechanism. Plans to move to Proof-of-Stake Potential single central points of failure in Ethereum system Infura (node cluster) is hosted on AWS (=centralized) Vitalik Buterin as a benevolent dictator

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Third generation blockchains

Called blockchains of blockchains. Could be viewed as on- and

• ff-boarding hubs between different types of blockchains (e.g.,

Ethereum and Bitcoin) or public blockchains and legacy systems (SWIFT, ACH) Interoperability between varying existing and future systems Largely work-in-process Scalability solution for the entire blockchain economy Cardano, Polkadot, Cosmos, Tezos The above projects use (Proof-of-Stake) PoS or (Delegated-Proof-of-Stake) DPoS Extremely challenging to design. Huge coordination cost Considered much less secure than PoW

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Enterprise blockchains

Enterprise (private) blockchains are not real blockchain systems as used in Nakamoto (2008) They all have central point of failure/authority, thus they do not solve the Nakamoto (2008) problem (arising of costly legal disputes between transacting parties) Most likely will use other types of ledger (not blockchain) and they can reverse transactions if they want to Private blockchains suffer from data integrity problem, denial

• f service (DoS), and coordination problem

(=interopearbility between different participants) E.g., recent ban by GitHub for people living in Iran, Syria, and Crimea (GitHub is now owned by Microsoft) Microsoft now also offers BaaS (Blockchain as a Service) product via Microsoft Azure

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Decentralized Finance (DeFi) movement

Building the whole new alternative financial system on decentralized platforms using Ethereum Loans Insurance Securities Real world assets Stablecoins Derivatives Exchanges Security and identity Payments Applications Why Ethereum not Bitcoin? Easier to write and execute smart contracts.

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Cryptocurrencies as a new asset class

Orthogonal to stocks, bonds, and gold (near zero correlation)

This is what is generally believed One of many valuation proposals with significant implications

Source: Circle Research

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Orthogonality as a sought for asset class property

A near zero correlation between cryptocurrencies and other asset classes should decrease portfolio riskiness and increase its risk-adjusted return Long-term improvement of portfolio performance Implicit assumption: positive expected return on bitcoin Assets of such property are hard to obtain in real world

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Relationship between Bitcoin and other cryptocurrencies

Within the crypto asset ecosystem almost all exchange traded cryptocurrencies (around 2,000) have betas greater than 1 wrt

• Bitcoin. Besides a few with negative betas (e.g., exchange tokens

like BNB).

If Bitcoin project fails, then all other outstanding projects will most likely fail as well. Why is Bitcoin so important? First ever, longest, and most secure public chain. Major point of reference for the entire ecosystem. Most of the 2,000 cryptocurrencies are ERC20 tokens, thus not bona fide cryptocurrenices.

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Bitcoin dominance as a key factor predicting performance

• f other cryptocurrencies

The correlation depends on Bitcoin dominance. Rough approximation: positive with beta >1 when dominance declines and negative with beta <1 when dominance rises.

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Bitcoin emerging as a hedge for global risk

Intriguing BTC price dynamics in 2019. Since first months of 2019 positive correlation with gold, negative with S&P500, and negative correlation with USD

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Alternative thesis: Bitcoin moves in unison with S&P 500

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Long-term picture using regression

Comparative return of Bitcoin and S&P 500

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Tom Lee (Fundstrat Global Advisors) yesterday

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Uniqueness of the new asset class

Crypto assets lie on a spectrum ranging from currency to commodity to security to collectable. Some assets have features that are all four. In addition they may include some utility characteristics E.g., Bitcoin can be a store of value, currency, collectable (also utility = subsidy for mining; some features of security = hard fork as a value distribution) NEXO (ERC-20 token) provides instant crypto credit lines using a smart contract. First crypto credit card - using NEXO money with collateral provided. In August 2019 it paid out dividend to its owners (annualized dividend yield of 12.73%). Crypto assets are financial instruments that defy the traditional asset class classification.

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Institutional inflows into the crypto space

Coinbase start-up firm Based in San Francisco. Latest valuation at $8billion. 30M

• users. $150bn trading volume

Coinbase Custody is standalone independently-capitalized business to Coinbase. Fiduciary under NY State Banking Law According to the Coinbase CEO, the custody business has been receiving $200-$400M in new crypto deposits from institutional investors per week in 2019

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Get-off-zero movement

Initiated by Morgan Creek Digital and its founder, CIO and managing director Mark Yusko Notable successes: In February 2019 $4.2 billion Fairfax County Employees’ Retirement System and the $1.5 billion Fairfax County Police Officers Retirement System (both public pension funds) invested less than 1% of their assets in blockchain technology firms via $40M venture-capital fund The objective is to convince insitutional investors to invest in bitcoin relatively tiny amount of their AUM to boost their portfolio returns (based on the zero correlation argument) There are about 150 active hedge funds with $1B AUM in cryptocurrencies

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Bitcoin ETF

Logical consequence of the maturing crypto market Currently there are 3 different ETF proposals under SEC revision

VanEck Solidx, Bitwise, and Crescent Crypto

VanEck appears to have the highest chances of being accepted

Solidx will provide custody solution Actively managed ETF Invested in ”physical bitcoin” and fully insured

SEC Commissioner Hester Pierce (aka ”crypto mom”) says ”the time is right” for Bitcoin ETF

SEC’s Senior Advisor for Digital Assets and Innovation, Valerie Szczepanik ”agency is moving slowly (...) because it needs to be cautious”.

Ultra cheap ETFs comprise huge market. $516 billion of inflows in 2018. The same year introduced 49 new managers and 877 new products.

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SEC rejects NYSE Arca Bitwise Bitcoin ETF Trust

On October 9, 2019 SEC rejected the ETF proposal by NYSE Arca and Bitwise because ”it did not meet legal requirements to prevent market manipulation or other illicit activities” (Coindesk) On September 13, 2019 VanEck Solidx withrew its ETF proposal

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Latest crypto projects by legacy finance

Fidelity Digital Assets — enterprise-grade custody and execution services for institutional investors.

Platform is already in use for certain clients. Fully operational in June 2019 Crypto optimistic institution. Fidelity has been mining Bitcoin and Ethereum since 2017.

Bakkt by ICE — custody for digital assets (Bakkt Warehouse) as well as daily and monthly physically settled Bitcoin futures contracts.

Bakkt will self-certify its Bitcoin futures contracts with CFTC. Received green light in August 2019 Ready to launch September 23, 2019

Swiss bank Vontobel lunched regulated purchase, custody and transfer of cryptocurrencies in January 2019 (partnership with technology firm Taurus).

Swiss financial institutions are crypto friendly. SIX Swiss Exchange introduced first Bitcoin futures (ahead of CME and CBOE).

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Bakkt volume so far

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Part II: Disrupting current intra-industry processes

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Problems with the existing infrastructure

Financial industry relies on a global network of trusted intermediaries that need to coordinate processes to transact. Shared information is necessary for transaction completion These intermediaries are typically concentrated, opaque, and domiciled in different jurisdictions Consequently, transactions take long time, are error prone and costly (e.g., several days worth of carry; locked-in capital ratios) DLT could introduce overwhelming procedural efficiencies to these processes

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Collateral management

Multi-party business process that grew in complexity in the aftermath of the 2007-2009 financial crisis. Some firms outsource collateral management and rely on triparty

• agents. Transacting parties communicate with the agent

independently by phone or mail. Moreover, collateral schedules are still set using pen and paper, Excel spreadsheets. Currently, collateral providers do not observe in real time clients exposure to a specific counterparty. Regulators do not see in real time what collateral firms receive and hold. Stricter liquidity requirements, capital buffers, and leverage ratios under Dodd-Frank, Besel III and IV.

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Improving collateral management using DLT, smart contracts, and cryptocurrencies

Collateral provider will be able to instantaneously observe the clients exposure to a specific counterparty written in DLT. Regulators will know in real time what collateral firms receive and hold. Collateral will be processed using smart contracts that will replace some existing intermediaries (high-tech vendors, triparty agents). The value will be transferred across multiple entities in a seamless and audible manner using digital tokens issued on a blockchain. The above will bring massive efficiency improvements, risk reduction, and cost savings. Private permissioned blockchains are not free of coordination, data integrity, and thus legal frictions. The ultimate adoption must come via public DLT.

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Part III: Asset fractionalization (tokenization)

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What is tokenization

Process of converting rights attached to the real or financial assets into programmable tokens deployed on the private or public blockchain. Value digitized into cryptoequity, cryptodebt, cryptocommodities, cryptoproperty, cryptocollectables, etc. Additional layer of programmable utility can be added to digital

• tokens. Voting rights. Distribution rights.

Digitalization leads directly to automatization.

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Why is tokenization unavoidable

Virtually infinite asset divisibility Greater liquidity Frees up investable capital Near-zero transaction costs Near-instantaneous settlement No counterparty risk Borderless flow of value Tradeable 24/7/365 Easily implementable margin trade facilities, OTC, and derivative instruments built on top of DLT

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Greater asset accessibility and affordability

Currently, markets for the most part are segmented and certain asset classes are available only for the largest institutional investors. High nominal prices restrict many potential buyers from participating in different asset markets (family offices, endowment funds, wealthy individuals, smaller institutional investors). Tokenization allows for the divisibility of assets and thus their greater accessibility by all types of investors.

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Freeing up capital invested in illiquid assets

The size of the markets for illiquid asset classes exceeds market capitalization of public equities listed on NASDAQ and NYSE (above $30 trillion). Their share in the portfolios managed by institutional investors has increased dramatically over the last decades. Commercial real estate, equity held in private firms, venture capital, trusts, partnerships, corporate bonds, municipal bonds, institutional infrastructure, fine arts, etc. Costly to trade and imply uncertain waiting times due to legal, accounting, regulatory and other transactional frictions. In some cases illiquidity horizons can last several decades. Because of illiquidity investors may choose not to hold diversified (market) portfolios, which affects current prices of the assets and the distribution of their future returns. Illiquid assets can be divided into myriad of digital tokens and be readily marketable via DLT.

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Blurring the lines between public and private equity placement

One of the main motives for the IPO is to create liquidity for existing shares of common stock. However, the transaction is typically extremely expensive for the company and costs 4-7% of the gross IPO proceeds, paid in underwriting fees plus accounting, legal, and other costs. IPO can be replaced by a Security Token Offering (STO) where the digital representation of the common stock is registered directly on the blockchain, thus circumventing costly and time-consuming bureaucratic procedure for the issuance, registration, and sale of public securities. DLT enables STO of private securities (next to public offering) thus creating a liquid secondary market which is almost non-existent today. Private placement can avoid registration with the SEC if the

• ffering is below the threshold indicated in Section 12(g) of the

Exchange Act (unregistered offering).

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Stablecoins

Cryptocurrency without the excess volatility. Backed by fiat money in one-for-one pegged-exchange-rate regime. Enjoys all benefits of a cryptocurrency (speed of execution, low cost, security). Does not require heavy investment on expensive physical infrastructure, yet can have global outreach through open electronic networks (Internet) and simple mobile phone applications. Used for cross-border payments, loan origination, settlement, interest rate payments, corporate treasury management, etc. Clear advantage of legacy institutions vis-a-vis startups with little reputational capital acquired.

Tether stablecoin failed to provide timely audit. At some point, it was priced as low as $0.88

Legacy projects in this arena: ”JPM coin”, ”global coin” by Facebook, Utility Settlement Coin by a consortium of largest global banks (BNY Mellon, Barclays, Credit Suisse, and others).

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Stablecoins by existing US listed corporations

Project Libra by Facebook announced June 2019 to be released in 2020

Backed by ”bank deposits and short-term government securities in currencies from stable and reputable central banks” (some call the project ETF) Run by Libra Association (non-for-profit). 100 members serving as validators for the network (nodes) Private blockchain (in fact, Libra uses a different type of ledger). AWS is recommneded as a server host Dividends will be paid to investors who provided capital to the system ($10M membership fee) Facebook will effectively become a bank. There is not much the US authorities can do to stop the project. France and Germany strongly against (not sure how effectively the use of Libra could be blocked by some states)

Wells Fargo (announced September 2019); Walmart (filed for patent August 2019)

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Central bank stablecoins

In July 2019 People’s Bank of China (Chinese central bank) reportedly began working with other market participants and institutions on a central bank digital currency. According to Jeremy Allaire (CEO Circle) PBC has been working in this arena for the last 4 years Far ahead of other central banks Strategic (expending its role in trade, the role of RMB in global economic activity, more global convertibility of RMB, more interaction with RMB on the world’s stage) Each central bank will eventually issue a stable coin

Link to video Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 44 / 46

Crypto-collateralized contracts using Bitcoin blockchain

Company Abbra offers the purchase of fractional number of a selection of US stocks (e.g., Tesla, Uber, Facebook) as well as some ETFs for retail customers in over 150 countries.

Abbra does not allow to trade the stocks/ETFs themselves but only Bitcoin representation of their value. Clients do not have ownership titles to stocks/ETF, however, they are exposed to their price action (synthetic financial instrument). Thus, this is not tokenization (yet). Non-custodial investment platform. Customers control their own assets

• n their mobile phones (private keys).

Abra is the contract counterparty.

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Thank you very much for your attention! Feel free to contact me at m.mazur@ieseg.fr or mieszkomazur@gmail.com Twitter handle: @MazurMieszko (I re-tweet a lot about everything crypto)

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