Guiding Seminar V Flashcards
DeFi and Future of Finance
• Decentralized finance as a potential solution to problems created by the current system that result in lower economic growth and higher inequality:
o Centralized control of money supply (in DeFi admins have little to no control)
o Limited access to money and financing (provides large underserved groups of population with direct access to financial services)
o Inefficiencies such as high transaction costs (can easily achieve transactions of high volumes, some users are incentivized to monitor, open source nature allows for constant improvements and competition)
o Lack of interoperability (easier to cointegrate products because they all rely on the same basics)
o Lack of transparency (all parties can observe contract clauses, counterparties, the flows of funds)
• Blockchain as the foundation of DeFi: allows number of parties to operate under some shared rules and exchange data without trusting each other
• Consensus protocol (Proof of work) as a key mechanism
• Cryptocurrency: the attempt to create a decentralized token (money), based on Blockchain. Their limited supply, together with Blockchain system, is what assures the possibility of value behind cryptocurrencies. Blockchain ensures that no one can post a false transaction without actual ownership of the asset (public + private key).
• Smart contract: program (piece of code) on blockchain that takes certain rules [of contract] written by a programmer and executes when these rules are met. Implemented on ETH, requires gas fee.
• Oracles: data sources that contain information of external world so that, for example, BTC knows what is happening in the real world
• Stablecoins: cryptos that avoid being volatile and maintain their peg, can be fiat-colletarized, crypto-colletarized, or non-colletarized
• Fungible tokens: divisible tokens that have (at least) some basic functionality such as being able to be used in transactions. Can be classified into:
o Equity tokens: represents ownership of assets
o Utility tokens: required to utilize some functionality of smart contracts (being collateral, represent stake)
o Governance tokens: represent stake and are used in determining voting rights when updating the system
• Non-Fungible Tokens: represent unique ownership of an unique asset (art, real estate)
• Fungible token’s supply adjustments:
o Burn: reducing supply by manually sending them to unowned addresses or building contracts that restrict their spending
o Mint: increasing supply through smart contracts
o Bonding curve: pricing supply (cheaper to mine tokens at the early stage)
• Loans: either collateralized or flash loans (paid back immediately in the same transaction, zero counterparty risk)
Free Markets to Fed Markets: How modern monetary policy impact equity markets
• Problem: what are the drivers of the disconnection between the stock markets and the real economy? What is the FED’s impact on financial markets?
• The relationship:
o The FED reacts to negative stock returns, or bad economic outlook by expanding their balance sheet
o The market reacts positively to the expansion of the FED’s BS
• The channels by which the FED impacts stock markets:
o Impact on long-term bond yields (long-lasting reduction in longer-term interest rates)
o Impact on future health of the economy (lower interest rates, meaning more accessible borrowing)
o Scope of the Asset Purchasing Programme during Covid (signaling that they are ready to do whatever it takes)
• More cyclical (more sensitive to economic conditions) sectors were affected the most by the FED’s intervention: consumer durables, energy, hi-tech, whereas there was very little impact on utilities or wholesale/retail
• Different counterfactual scenario analysis shows that around 1/3 to ½ of the market rebound can be contributed to the FED
When Selling Becomes Viral: DISRUPTIONS IN DEBT MARKETS IN THE COVID-19 CRISIS AND FED’S RESPONSE
• Disruptions: disconnection between the bond and CDS spreads for both investment-grade and high-yield debt
• Traditional channels do not explain such disruptions:
o If future expected cash flows were impacted then CDS spreads should have also been affected
o If increased default risk premiums were the cause then CDS spreads should have changed as well as the impact should have been larger for junk bonds, which was not the case
• More realistic explanation: investors were in need for cash and sold the most liquid bonds (investment-grade) to raise cash, which brought down prices, brought up yields
• The disruptions were reversed by the intervention of FED: first by repurchasing investment-grade bonds, followed by the repurchase of riskier debt
• Conclusions:
o Traditional explanations of expected cash flows, default risk premiums do not fit the narrative due to relatively stable CDS, improportional effect on investment-grade bonds
o Typical arbitrageurs were unable to equate the prices across markets
o Some participants in the market became unwilling to buy some assets relative to others: need for cash was what created these disruptions
Is there a zero lower bound? The effects of negative policy rates on banks and firms
• Monetary policy transmission: how much of interest rate cut is actually passed through to corporate deposit:
o When the cut is happening and rates still remain above the ZLB, banks pass on most of the policy rate cuts within 12 months.
o When the cut is happening and rates still remain around ZLB, there is little pass through even after a year of only 20% of the original cut is reflected. This supports hard ZLB - concentration around 0%.
o When cut happens and rates pass the ZLB, pass through increases but only for financial sound banks. ZLB stops being temporary policy.
• Key findings:
o Sound, investment-grade banks are more likely to charge negative rates on deposits because they have high market power and they face high demand from firms that want to access safe assets (banks do not experience large deposit outflows)
o Firms exposed to negative interest rates no longer sit on cash because it becomes expensive and instead invest it (fixed assets grow, firm liquidity decreases), which could make the economy as a whole better off
o Banks that charge negative interest rates are more profitable and lend more because lending becomes cheaper and more firms are willing to borrow
Exchange-traded funds 101 for economists
• In contrast to mutual funds, investors do not trade the funds directly, ETFs involve Authorized Participants: a counterparty that creates and redeems ETF’s shares, increase the transparency of markets by keeping ETF prices close to their NAVs and improve liquidity.
• ETF’s shares can be shorted, lent and bought on margin.
• 3 types of ETFs can be distinguished:
1. Equity ETFs (market cap based, tracking industries, smart beta/factor ETFs)
2. Fixed Income ETFs (initially portfolios of safe bonds, now also bank loans and high-yield bonds)
3. Commodity ETFs (for hedging inflation or diversification purposes)
• Most of the potential issues of ETFs are rather misconceptions:
o Closure of ETFs (as there are underlying assets, there is something to be returned in case of liquidation)
o Short selling of ETFs (bankruptcy might arise if due to shorting the aggregate long and synthetic long positions exceed the outstanding number of ETF shares)
o Securities lending by ETFs (very unlikely to be a threat due to regulation on ETFs, also, in theory, should improve price liquidity and efficiency)
o Flash crash (most likely does not originate from structural problems of ETFs as such)
o Liquidity mismatch (if APs step away, there could be liquidity problems for small ETFs, but big ones have many, many APs)
o Impact on underlying markets (might amplify pricing errors in underlying stocks, but the effect on market is unclear)
Risks and returns of cryptocurrency
• Testing popular assumptions about the nature of crypto and their drivers.
• Risk exposures: crypto has low exposures to traditional asset classes (stocks, currency, commodities, macroeconomic factors), meaning that they have their own predicting factors. Markets don’t consider cryptocurrencies to be a medium of exchange equivalent to currencies or a store of value equivalent to precious metals
• Network factors are useful predictors of crypto returns:
o Momentum: increase in daily/weekly returns increases following day/week returns
o Investor attention: high investor attention (Google searches) predicts high future returns
• Production factors such as electricity or computer hardware costs do not predict crypto returns
