Emerging Topics Flashcards

Question

List the two approaches to protect the lender on a decentralized lending platform ## Footnote LO 1.2.4

Answer 1

1. flash loans may be used and if the borrower does not repay with interest, the transaction and its results are nullified, 2. loans may be fully secured using collateral which is locked in a smart contract and released only when the debt is repaid.

Answer 2

1. Collateralized debt positions 2. pooled collateralized debt positions 3. P2P collateralized debt markets

Answer 3

Collateralized debt positions (CDP) are loans which use newly created tokens. The number of new tokens created is dependent on the target collateralization ratio, the value of the collateral (the cryptoassets), and the target price of the tokens generated. New tokens serve as loans which are fully collateralized, do not involve a counterparty, and allow user access to a liquid asset with the collateral providing market exposure.

Answer 4

Decentralized derivatives are tokens whose value comes from the performance of an underlying asset, the outcome of an event, or the development of another observable variable. The price of an asset-based derivative token is a function of the performance of an underlying asset. Stocks, commodities, and cryptoassets can all be tokenized. Inverse tokens where price is based on an inverse function of underlying asset performance offer short exposure to cryptoassets.

Answer 5

Although this platform offers the advantage of redemption independent of the issuer, users bear the risk associated with their debt position being impacted by others’ asset allocations.

Answer 6

On-chain funds provide investors with a basket of cryptoassets (along with myriad investment strategies) without requiring an investor to hold individual tokens. Rather than going through a custodian, cryptoassets are contained within smart contracts where investors can observe their balances, withdraw, or liquidate them at any time. Fund tokens are issued from smart contracts and transferred into investor accounts. The tokens serve as evidence of partial fund ownership and allow for the redemption or liquidation by token holders of their share of fund assets.

Answer 7

Closing out an investment involves burning fund tokens, selling the underlying assets through a decentralized exchange, and compensating investors with the ETH-equivalent of their ownership portion of the basket of assets.

Answer 8

1. transparency - all transactions are publicly observable and financial data are publicly available 2. efficiency - smart contracts allow for the quick settlement of transactions, 3. composability - myriad investment possibilities due to the interconnection of protocols and applications 4. accessibility - an open and accessible financial system

Answer 9

1. operational security - internal and external attacks from malicious parties 2. smart contract execution - security and coding errors in smart contracts. 3. dependencies - between smart contracts and decentralized blockchains 4. scalability - capacity of a blockchain to meet growing demand for its usage 5. illicit activity - related to minimal regulations within a decentralized environment 6. External Data - Oracles and the risk of highly centralized contract executions

Answer 10

Web 3.0 builds upon previous generations of the internet by allowing for a read-write-execute interface.

Answer 11

Decentralized finance (DeFi) is a component of Web 3.0 that democratizes access to financial services through peer-to-peer (P2P) networks. Blockchain removes the need for financial intermediaries to be involved in financial transactions. DeFi enables algorithms to automate some traditional finance tasks and users to connect directly with others in an anonymous way.

Answer 12

Tokenization is the process of associating an asset with a digital identifier and metadata. Through this innovation, an asset can be broken down into smaller parts to facilitate storage and transferability. Fungible tokens are interchangeable, while non-fungible tokens (NFTs) are unique assets.

Answer 13

In terms of resource allocation, the traditional economy uses technology to assist humans in allocating resources; while in the digital economy, algorithms streamline the resource allocation process.

Answer 14

In terms of location independence, the traditional economy is reliant on physical locations, but the digital economy is free from the constraints of a storefront.

Answer 15

In terms of growth, the traditional economy has some scalability issues that cap growth; while in the digital economy, growth can be accelerated through better management of data and resource allocation.

Answer 16

The digital economy allows for near-real-time adjustments to supply and demand, while the traditional economy has built-in lags.

Answer 17

1. Asset tokens 2. Payment tokens 3. Security token 4. Utility tokens 5. Governance tokens 6. Reward tokens

Answer 18

1. Smart contracts - enable a pre-coded algorithm to ensure that a specified condition is met before a tansaction is finalized. 2. decentralized identifiers - digital fingerprints to identfy an asset or a person in a digital environment 3. Tokenizations - large datasets and assets with a large file broken down into smaller pieces (known as an interplanetary file system) 4. Distributed ledgers - a database that is shared and synchronized across multiple locations

Answer 19

Blockchain technology makes the infrastructure. there are four layers of functional building blocks: 1. Application layer - a P2P application for an individual service. 2. Aggregation layer - connects related services together 3. Protocol layer - introduces the software necessary to conduct the DeFi action 4. Asset layer - unit of value used to enact a given transaction

Answer 20

* lower liquidity * slower trading speeds * higher fees * a need for growth in blockchain interoperability * potential for fairness concerns * infrequent smart contract errors * regulatory ambiguity * experimentation with user interfaces * potential for market manipulation

Answer 21

by increasing liquidity and risk management options while decreasing settlement times and transaction costs.

Answer 22

* Creating a regulatory sandbox for new product exploration * offering regulatory guidance on desired behaviours * reviewing existing legislations and adjusting where feasible * enforcing existing laws * creating new DeFi solution that are specicially designed to be regulatory friendly * building DeFi RegTech tools that can use technology to search for bad actors

Answer 23

* consumers - high asset price volatility and the potential for fraud * financial markets - market risk, counterparty risk and liquidity risk * software failures that could introduce transaction risk and smart contract risk * operational errors including human errors and governance issues * regulatory issues - DeFi is currently borderless which makes regulation complex * emerging issues - new concerns that could impact the stability of financial markets that periodically emerge.

Answer 24

Tokenization has the potential to increase liquidity by making units more easily tradeable and lock-up periods less important. It has the potential to reduce settlement times because blockchain can connect deals very quickly. Using the blockchain can also increase risk management while reducing transaction costs.

Answer 25

1. **Function/task-relevant**: metrics are aligned with goals and objectives of the organization. 2. **Flexible and adaptive:** metrics are revised based on investment experience, market risk, and market uncertainty. 3. ** Consistent:** the performance of an organization can be assessed by viewing the metrics of its individual parts. 4. **Transparent and parsimonious:** metrics should be simple to understand and apply. 5. **Mutually exclusive and collectively exhaustive (MECE):** metrics should be available for key resources and activities while reinforcing responsibilities and motivating employees.

Answer 26

* Endowments * Foundations * Insurance Companies * Pension Funds * Sovereign Wealth Funds * Family Offices * Superannuation funds

Answer 27

Measurements represent observable facts while metrics are measurements put into a broader context to provide information. Metrics which are actionable across many contexts become knowledge.

Answer 28

1. idiosyncratic advantages 2. time horizon 3. organizational ambidexterity

Answer 29

Environmental enablers are the intangible or untraded advantages derived from an organization’s given environment. These enablers include culture, governance, and technology.

Answer 30

1. People 2. Process 3. Capital 4. Information

Answer 31

Intermediate outputs connect environmental enablers and productions inputs to results. They include: - alignment - commitment - knowledge management

Answer 32

1. Culture - measures: investment beliefs, success focused, net promoter rankings 2. board engagement - measures: delegations utilized, opportunities reviewed 3. Technology - measures: percent of budget, technology satisfaction

Answer 33

1. Peoples - measures: work product, personnel matters 2. process - measures: risk governance 3. capital leverage - measure: capitalizing on capital 4. information - measure: data ready

Answer 34

1. Alignment - measures: goal focused, goal consistency 2. commitment - measure: time horizons 3. knowledge management - measure: knowledge sharing, knowledge quality

Answer 35

Investment performance - measures: portfolio health, cost efficiency

Answer 36

1. Idiosyncratic advantages 2. time horizon 3. organizational ambidexterity

Answer 37

* Equity risk * illiquidity premium * size (small-cap bias) premium * value premium

Answer 38

The equity risk of PE is higher than implied by smoothed returns; PE investors may overpay for PE due to a preference for smoothed returns.

Answer 39

A small-cap equity index is likely to be a more appropriate benchmark for PE than a large-cap index because buyout targets typically have smaller capitalizations.

Answer 40

Even if the illiquidity premium is offset by overpayment for PE investments (i.e., because investors overpay for smoothed returns), PE investors should still expect a higher rate of return than for public equity due to the small-cap bias (size tilt) and the higher equity beta (equity risk tilt).

Answer 41

A public benchmark comparison is inappropriate because PE has more equity risk. Private equity (PE) is more leveraged than the average publicly traded stock (100%–200% debt-to-equity ratios, versus about 50% debt to equity for public companies).

Answer 42

To properly evaluate the illiquidity premium and alpha for PE returns, a leveraged, small-cap index is a better match. The Russell 2000, levered by a multiple of 1.2, is a more appropriate benchmark.

Answer 43

PE outperformed large- cap and small-cap stocks by approximately 2.3% based on arithmetic means. That is a 9.9% PE return versus 7.5% S&P 500 return and a 7.6% Russell 2000 return. P/E outperformed an unlevered Russell 2000 value index by 1.4% and underperformed an unlevered basket of small-cap value stocks by 1.6%.

Answer 44

After adjusting for leverage, PE outperformed small-cap equities (i.e., the Russell 2000 return, multiplied by a leverage factor of 1.2) by a mere 0.7%.

Answer 45

PE cash flows, in the same amounts and at the same times, are deployed into a public stock market index (PME) to understand how the benchmark would have performed with the same investment amounts and same timing of investment. The amount of capital generated by the PE strategy is compared to that generated by the public market investment. IRR is not time weighted (the siming and size of cash flows influence the IRR.

Answer 46

1. IRRs are not time weighted. The timing and size of cash flows influence the IRR. 2. IRR assumes that all cash flows can be reinvested at the IRR rate, (This is the faulty reinvestment rate assumption problem). General partners can time both capital calls and deal exits to increase IRRs. The reinvestment rate assumption means that IRRs can be over- or understated, relative to true returns.

Answer 47

1. more capital committed to PE as a result of strong pre-2006 PE performance, higher allocations to the asset class, and positive press, such as David Swensen’s promotion of Yale’s endowment model; 2. lower levels of leverage following regulatory changes that came out of the 2007–2009 financial crisis; 3. a greater competition for deals, as cash-rich companies seek acquisitions that would once have been available for PE investments.

Answer 48

When netting the two equations (PE vs. public net-of-fee ER) it becomes clear that a richening of PE and declining leverage largely explain the deteriorating edge PE has over public equities.

Answer 49

A value creation plan (VCP) is a formal plan for a private equity firm to unlock value for investors when they purchase a company.

Answer 50

1. Operational Improvements 2. Top-line growth 3. Governance engineering 4. Financial engineering 5. Cash Management

Answer 51

The category of VCP employed varies based on deal type, fund ownership interest (i.e., minority or majority stake), growth strategy (i.e., organic or inorganic growth), and geographic focus. Different combinations of action items are needed depending on the goals of the strategy.

Answer 52

1. Early-stage firms 2. Growth-focused firms 3. Buyouts 4. Secondaries 5. Turnarounds

Answer 53

Deals involving early-stage firms also place significant emphasis on top-line growth and modest use of governance engineering.

Answer 54

Growth-focused deals emphasize top-line growth, but they also focus more on governance engineering than early-stage deals.

Answer 55

buyout firms have the highest emphasis on top-line growth, governance engineering, and financial engineering.

Answer 56

top-line growth and governance engineering.

Answer 57

Financial Engineering

Answer 58

As the number of action items pursued at the same time increases, the success rate of the VCP decreases. Taking on too many action items at the same time will spread PE managers too thin and lower the chances of success when the deal is exited.

Answer 59

Governance engineering and operational improvements

Answer 60

Deal duration (longer is better), deal size (larger is better), and majority ownership all have a positive effect on the chances of success. Focus on inorganic growth often decreases the chances of success.

Answer 61

Resource constraints, specialization, and diminishing returns from elevated deal complexity all have an impact on deal implementation.

Answer 62

Primary concerns are a portfolio of a smaller number of deals that are homogenous in size coupled with a minority stake. Vintage year also has an impact, but it is less able to be controlled due to time-period sensitive macroeconomic factors.

Answer 63

net positive return on investment and benchmark-relative returns. The key to unlocking above average returns is using the right combination of action items.

Answer 64

The common themes that earned above average returns were - combining top-line growth - governance engineering. Below average returns often resulted from combining: - cash management or operational improvements with other VCPs - or by focusing on more than three VCPs at the same time. There is no single strategy that will consistently produce superior returns.

Answer 65

1. Increased employment 2. Sales 3. EBITDA 4. Capital intensity

Answer 66

Limited partners (LPs) are typically unable to invest their entire capital at once and must do so in separate installments over several years. When managing liquidity, LPs must consider how to invest uncalled capital while dealing with the uncertainty surrounding future capital calls.

Answer 67

When part of a portfolio is invested in cash or cash-equivalent securities, as opposed to securities which are the portfolio’s main focus, the cash component has no market exposure. In a situation where markets are rising, cash tends to underperform markets and cash drag is negative. Conversely, where markets are falling, cash will tend to outperform the market and cash drag will be positive.

Answer 68

Given that only a portion of capital is actually drawn and invested at a given time, overcommitting capital may be necessary to reach the desired investment alocation.

Answer 69

Diversification is complicated due to minimum investment amounts, the size of illiquid allocations, the number of investment horizons required, and the number of managers required per investment horizon

Answer 70

Using public market equivalent (PME) assets that possess risks and returns close to those illiquid investments, had the funds been invested immediately upon commitment.

Answer 71

Significant drawdowns at an early stage may permanently impair a portfolio and increase shortfall risk. Furthermore, this situation is exacerbated if the drawdown occurs simultaneously with cash outflows required for capital calls.

Answer 72

A liquidity tiering framework involves having the risk and investment horizon associated with each allocation match the commitment rate. Liquidity tiering attempts to benefit from the upside capture of PME assets while avoiding the downside aspects of fully investing in PME assets.

Answer 73

Returns can be maintained at a similar level to PME assets (i.e., higher returns than cash), but the risk associated with missing capital calls resulting from unexpected market downturns will be reduced (i.e., lower risk than PME assets). Tiering is a systematic way to invest uncalled capital, manage future capital calls, and minimize cash drag. In addition, tiering involves ongoing adjustments to reduce losses, especially during market downturns, by reducing the size of higher-risk tiers.

Answer 74

1. Fully invested in cash or cash equivalent (highest cash drag) 2. Fully invested in PME assets (lowest cash drag, highest returns with significant volatility and high shortfalls) 3. Liquidity tiering based on average call rates (lower returns than PME, reduced shortfalls than PME, more cash drag than PME) 4. Liquidity tiering based on the highest 10th perccentile of annual call rates (large reduction in shortfalls vs average tiering, more cash drag than average tiering)

Answer 75

1. matches the investment horizon of the assets to the timing of the estimated liabilities. 2. It involves ongoing adjustments to reduce losses, especially during market downturns, by reducing the size of higher-risk tiers.