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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 1 / 46

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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 2 / 46

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 download Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 3 / 46

Part I: Introduction Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 4 / 46

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. Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 5 / 46

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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 6 / 46

Well-known brands accepting bitcoin as of May 2019 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 7 / 46

Bitcoin can trigger strong emotions... Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 8 / 46

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] Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 9 / 46

You don’t need Bitcoin to launder money. You can do it a ”legal way” at a bank Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 10 / 46

Part II: Bitcoin as a new category of investible asset with unique properties Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 11 / 46

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) Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 12 / 46

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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 13 / 46

Third generation blockchains Called blockchains of blockchains. Could be viewed as on- and off-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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 14 / 46

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 of 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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 15 / 46

Decentralized Finance (DeFi) movement Building the whole new alternative financial system on decentralized platforms using Ethereum Loans Derivatives Insurance Exchanges Securities Security and identity Real world assets Payments Stablecoins Applications Why Ethereum not Bitcoin? Easier to write and execute smart contracts. Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 16 / 46

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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 17 / 46

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 Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 18 / 46

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. Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 19 / 46

Bitcoin dominance as a key factor predicting performance of 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. Mieszko Mazur (IESEG) DLT and Financial Services Sector 11 October 2019 20 / 46